David Beckworth pointed me to an interesting discussion at a recent Brookings Panel. Olivier Blanchard and Ben Bernanke presented a paper assessing various factors of the recent inflation spurt, highlighting the role of supply issues related to food, energy, shortages, etc. overstimulation of demand. They also argued (correctly in my view) that inflation turns from transient to permanent when it becomes rooted in excessive wage growth. The initial push for inflation was high prices relative to wages; the current problem is excessive wage growth.
In his discussion, Jason Furman presented a slide showing his interpretation of their framework for aggregate demand shocks:
He compared this with his preferred framework for analysis:
Long-time readers will recognize that this is also my preferred way of thinking about demand shocks. By itself, real GDP tells us almost nothing about demand. In contrast, the NGDP is a reasonable approximation of aggregate demand. (This does not prevent experts from occasionally citing actual production and/or actual consumption data as “demand”, even if it is an EC101 level error.)
In the ensuing discussion, Bernanke objected that the implications of increasing the NGDP were ambiguous, as one could imagine a scenario in which the AS and AD curves would shift upwards (less AS, more AD , no change in production). Thus, a stable GDPR and a rising NGDP does not necessarily imply that the problem is primarily excess demand. He may have reacted to this slide from Furman:
From an accounting perspective, it looks like the inflation problem is 100% nominal, with real GDP roughly in line with trend. If I’m not mistaken, Bernanke’s argument is that in a counterfactual where the NGDP rose less sharply, it’s possible that production was lower (due to COVID, Ukraine, etc.) and that we still experienced excessive inflation (though probably less than what we actually experienced.)
Here’s why I prefer Furman’s approach: before COVID, unemployment was around 3.5%, so the economy was probably close to equilibrium. In this case, we should not have targeted rapid NGDP growth to reduce unemployment below 2019 levels. Instead, we should have targeted NGDP growth of around 2% plus the estimated trend growth of the RGDP by the Fed after 2019. In fact, we got a few trillion dollars of excess growth from the NGDP, or about 8% above trend. It would be shocking if this kind of rapid nominal spending growth hadn’t created high inflation, given that we were already close to full employment at the start of 2020.
This does not mean that Bernanke’s theoretical observation is incorrect. On the contrary, I suggest that his point is probably of limited relevance to this particular episode. COVID may have reduced overall supply by 1% or 2% between the start of 2020 and today, and the powerful demand stimulus has boosted production by roughly the same amount, leaving GDPR close to the trend. If the NGDP had been trending higher, production might have been 1% or 2% below current levels.
What seems implausible is that the change in overall supply over the past three years is close to exceeding demand by 8%. This kind of rapid growth in nominal expenditure is not a necessary condition for inflation (supply shocks can also boost the CPI), but it seems to me that it is quite close to a sufficient condition for a high inflation in the absence of some sort of genuine extraordinary increase in aggregate supply.
So, while Bernanke is correct that the rapid rise in the NGDP does not definitively prove that excess demand is the cause of the recent inflation overshoot, given plausible estimates of AS curve shifts, it seems very likely that the 8% overshoot of the NGDP is by far the main cause of high inflation.
Furman also made some very good observations about the difficulties of separating supply and demand shocks. For example, congestion at ports looks like a “supply problem”. But most of this congestion was not caused by a physical problem at the ports. According to Furman, import volumes at US ports were much higher in 2021 than in 2019. Instead, it is the extraordinarily large demand for goods in 2021 (partly driven by stimulus checks) that caused congestion in the ports. So, in a sense, even the “bottleneck” issues were partly excess demand, even though they looked like a supply issue. (Again, Blanchard and Bernanke acknowledged this problem in their paper.)
In EC101, we are taught that P and Y, taken in isolation, tell us nothing about supply and demand shocks. The NGDP is different. It measures prices multiplied by total nominal output or expenditure. Thus, the NGDP is a fairly straightforward reading of aggregate demand. Instead of looking at all sorts of sectors (food, energy, services, labor, investment, durable goods, exports, etc.), the NGDP offers a simple and elegant way of thinking about total demand in the economy .
Yes, the Fed is not directly targeting the NGDP. But there is no plausible interpretation of the Fed’s dual mandate where, starting from equilibrium, one should have NGDP growth well above 4% or well below 4%. In 2008-2009 we went about 8% below trend (which was then 5%), and in the last three years we went about 8% above. When the NGDP discrepancies are so large, it’s safe to say that the problem is primarily demand.
PS Of course, I’m in favor of NGDP targeting, which is another reason to prefer Furman’s framing of the question. But I would prefer his approach even if the Fed sticks to its current “dual mandate” approach. As St. Louis Fed President Jim Bullard once observed, the implications of the FACT (if symmetrical) are quite similar to targeting at the NGDP level.