A Two-for-One Targeting Deal?

Getting a Robust Inflation Target by Stabilizing Nominal Income Growth

This week on Macro Musings, Skanda Amarnath returns to talk about the Fed’s ongoing framework review and unpack his timely pieces on the Fed’s persistent blind spots—namely, its difficulty dealing with supply-side shocks and its failure to recognize the recent productivity boom—and discuss how both issues raise bigger questions about the robustness of the Fed’s current framework. If the Fed is serious about preparing for the next five years, it needs a strategy better equipped to handle uncertainty, supply volatility, and the limits of real-time data. As Skanda and I argue, that strategy starts with having a more reliable nominal anchor.

Enter nominal income targeting. As we explore in the episode, anchoring monetary policy to the growth path of total dollar income—or, equivalently, total dollar spending—offers a practical alternative to the current inflation-first approach. Rather than getting lost in the weeds of transitory versus persistent inflation or toggling between core, supercore, and market-based price indexes, the Fed would focus on something that is less distorted by supply shocks and more directly under its control: total dollar spending.

We’ve seen what happens when central banks lack that kind of clarity and fall into the inflation-myopia trap. In 2008, the Fed was slow to respond to a collapsing economy because inflation, driven by oil prices, was still elevated. It wasn’t until after Lehman failed that the FOMC finally cut rates again. The ECB made an even more glaring mistake in 2011, hiking rates twice in response to headline inflation just as the Eurozone crisis was gaining steam. Both institutions claimed to be flexible inflation targeters, but when push came to shove, they fixated on inflation prints and missed the deeper deterioration in nominal income growth. These aren’t just historical curiosities, they are cautionary tales. And unless the Fed rethinks its framework in a more systematic and forward-looking way, we risk repeating them.

Now, as we discussed on the show, it’s unlikely the FOMC will adopt a nominal income target. But it could still use it as a valuable cross-check and as a tool to guide its communication. In fact, there’s a way for the Fed to maintain an inflation target while anchoring monetary policy to a stable nominal income growth path. I will explain this two-for-one targeting deal in the rest of this newsletter. But before diving in, here is a short video clip from the show that captures some of the core challenges the FOMC faces in this framework review.

A Two-for-One Deal

So how can the Fed get a two-for-one targeting deal? Pat Horan and I answer that question in a recent article titled A Two-for-one Deal: Targeting Nominal GDP to Create a Supply-Shock Robust Inflation Target in the Journal of Policy Modeling (2024). We motivate it by discussing some of the challenges Skanda and I talk about on the podcast:

In short, the 2021–2022 inflation surge, vividly demonstrated how challenging it is for central bankers to successfully look through temporary supply shocks. It requires monetary authorities to overcome a knowledge problem—identifying inflation caused by temporary supply shocks in real time—while keeping inflation expectations anchored. These daunting tasks led former Fed Vice Chair Lael Brainard to conclude that looking through temporary shocks “sounds relatively straightforward in theory [but is] challenging to assess and implement in practice” (Lael Brainard, 2022).

This paper argues that there is a workaround solution to these challenges: nominal GDP (NGDP) targeting. It focuses central bankers’ attention on NGDP and allows them to look through short-term inflation movements. Nominal GDP level targeting (NGDPLT), where the central bank makes up for misses to the target, is especially attractive as it stabilizes aggregate demand and eliminates short-term swings in inflation caused by demand shocks, implying that any remaining shocks to inflation must be coming from supply shocks. NGDPLT, in other words, enables central bankers to see through short-term inflation movements caused by temporary supply shocks without having to identify the shocks.

NGDPLT also provides a credible nominal anchor since it stabilizes the nominal size of the economy and, therefore, keeps inflation expectations anchored. As a result, “a commitment to a nominal GDP level path is completely consistent with a commitment to a medium-term inflation target” (Michael Woodford, 2013, p. 6). Central banks, therefore, that target the growth path of nominal GDP also are effectively targeting medium-run inflation. NGDPLT, consequently, is a “two-for-one” targeting deal that allows monetary authorities to successfully look through temporary supply shocks.

To illustrate this two-for-one deal, here is a simple example from my policy brief on the framework review:

[A]ssume that the dollar size of the US economy is $25 trillion, and the Fed is targeting a nominal GDP growth rate of 4 percent per year, reflecting a desire for 2 percent inflation over the long run and a belief that potential real GDP growth is near 2 percent…

The first set of columns in table 1 shows what happens if there are no supply shocks. Nominal GDP grows by 4 percent ($1 trillion), and the spending is evenly split, as planned, between higher prices and real economic growth. The second set of columns shows what happens if there is a negative supply shock. The economy still grows by $1 trillion, but now three- fourths of that spending ($0.75 trillion) goes to higher prices; only one- fourth ($0.25 trillion) goes to real economic growth. The third set of columns shows what happens if there is a positive supply shock. The economy, again, grows by $1 trillion, but now three- fourths of that spending ($0.75 trillion) goes to real economic growth while one- fourth ($0.25 trillion) goes to higher prices…

FOMC members ignore the short- run changes to inflation caused by temporary supply shocks as they focus on keeping total spending growth at 4 percent. Fed officials, in other words, are automatically “looking through” supply shocks given that their focus is on aggregate demand growth. If these shocks are random and evenly distributed, then the implicit 2 percent inflation goal holds over time as well. The FOMC gets a “two-for-one deal”

How to Wordsmith the Two-for-One Deal into the FOMC Consensus Statement

Not only can the FOMC get a two-for-one deal with nominal income targeting, but it can officially state it in a way that, one, is consistent with where the FOMC appears to be heading with the framework review and, two, does not create a radical departure from the existing inflation target stated in the Statement on Longer-Run Goals and Monetary Policy

On the first point, I noted in an earlier post that Fed Chair Powell and recent FOMC minutes all indicate that the committee is likely to remove language in its consensus statement that covers the effective lower bound, makeup policy, and shortfalls from maximum employment. So we need to incorporate these changes.

On the second point, the FOMC still needs to reaffirm its commitment to a 2% PCE inflation target. What I am proposing is to retain the existing language around that target, but to anchor it within a stable nominal GDP growth path—one that is derived from 2% inflation plus the economy’s potential real GDP growth. The suggested language changes are outlined below:

Conclusion: A Framework Fit for the Future

As the Fed continues its framework review, it faces a defining opportunity to upgrade its strategy for a world of more frequent supply shocks, volatile real-time data, and heightened political scrutiny. Anchoring policy to a nominal GDP path does not require abandoning the 2 percent inflation goal. Instead, it strengthens that commitment by embedding it within a broader and more resilient nominal anchor.

By adopting a two-for-one approach—stabilizing both nominal income growth and medium-run inflation—the Fed can build a framework that is not only more robust to supply shocks but also easier to communicate and more transparent in its goals. The alternative is to keep patching up an inflation-first regime that has struggled to deliver consistent results in a supply-constrained world.

The framework the Fed chooses today will shape its credibility, flexibility, and effectiveness for years to come. NGDP targeting or some variant of it offers a path forward that preserves what works while fixing what doesn’t. It is not a radical departure, it is a pragmatic upgrade.