> With the Iran war unleashing the biggest inflation surge
After reading about “helicopter drop” mental experiment to explain effects of nominal shocks on inflation, I must confess that I am completely confused what would be the expected effects of such a real shock.
Like, imagine we wake up one day, and discover that the world now has 2X less oil, for whatever reason. What happens with inflation, and why? Naively one would think that oil gets more expensive => stuff that needs oil (≈everything) gets more expensive => inflation. But isn’t this confusing changes in relative prices with changes in price level?
What should I read to understand this better? My current confused thinking:
If the real reduction of oil output is temporary, we probably expect zero changes — real economy is made of flows, rather than stocks, so temporary disruptions are small in the grand scheme of things, and, in the small scheme of things, real stocks and financial futures should paper over real shock.
If the real reduction is long term (affects flows, rather then stocks), then, duality, we expect prices to jump up immediately, even we do have physical storage for the current moment. This _probably_ should mechanically push up what we call inflation. My understanding is that there isn’t a objective way to _define_ inflation, the same way we define NGDP, there’s only a specific measurement: a cost of a fixed basket of goods of “typical” consumption. Given that prices change immediately, and re-balancing the basket takes time, the _index_ goes up.
Then, on top of the accounting problem of updating the basket, there’s probably some real friction as well, people spending more money on fuel than what they’d prefer, given the price level, because they, eg, planned a trip while the price was lower, running down their stock of money.
But over the medium term, it feels like we should see not the cost of basket going up, but its composition shifting, such that there’s less oil in real terms: the shift in _relative_ prices making oil dearer, and a shift in composition of basket, keeping the overall price level the same.
But something does not add up here: we do really have less oil, the world _is_ poorer in real terms, shouldn’t that somehow get reflected in the price level?
And then, yeah, there’s of course this whole steering the wheel thing, where presumably our prediction should be that, assuming central bank targets inflation, real shocks should not affect inflation at all, and rather effect a change in the position of levers used by the central bank for steering…
You are of course right that if there's a negative oil supply shock, then oil consumption has to drop also, and relative prices must and will adjust, i.e., the price of oil must and will go up relative to the wage rate. So what happens to the price level?
In principle, one could have a severe supply shock without any change to the price level, but that would require workers to accept lower wages. Theoretically, that's no problem, but getting 180 million people to accept lower wages is a practical impossibility ("downward nominal rigidity"). But if you persist and use monetary policy to prevent the nominal price of oil from rising, then you wind up with a recession and a lot of unemployment instead --- people lose their jobs and you reduce oil consumption that way. Ouch!
The only practical answer is to allow oil-related prices to rise (gasoline, things requiring a lot of oil input) while holding the wage rate constant. You may wind up with above-2% inflation until relative prices come into equilibrium. This is why many people (including, I think, Scott) would agree that a fixed 2% inflation target is a bad idea, and what you want instead (if you can't have NGDP targeting) is FAIT (flexible average inflation targeting) where you allow inflation to run above target during negative supply shocks, and below target during positive supply shocks.
In your example of oil collapsing by 50%, it would put real strain on the economy through what I would call a demand compression sequence. Crude oil prices would skyrocket, and since demand for oil is inelastic, consumers and businesses would have to adjust their spending to offset the higher cost, cutting back on discretionary spending and investment across the board.
Normally, high prices would increase supply and resolve the issue over time. But a 50% supply collapse is most likely structural, meaning the high prices would persist rather than self-correct. That persistence is what makes this different from a typical supply disruption.
The result would be initially higher measured inflation, but the more important downstream effect is deflationary. As the broader economy contracts to accommodate permanently higher energy costs, spending shrinks, investment pulls back, and the overall price level follows downward. The 1 to 2 year outlook in this scenario is deflationary, not inflationary, even though the shock itself looked inflationary at the start.
It is worth noting this scenario describes a permanent structural collapse, which is not what we are seeing now. The current inflation surge is a risk premium on an active conflict, not a fundamental supply destruction event. Barring a dramatic escalation, I would expect prices to revert back toward trend, somewhere in the 0.3 to 0.5% monthly range, by the end of the year, even if the conflict remains active.
1. I see you have shifted from a steering the ship analogy to a steering the car analogy.
2. Japan has no RGDP growth because high tax rates have caused average expected after tax returns on investment to be negative. Monetary policy can do nothing to fix that.
3. Warsh's view on rates and policy are probably much less important than his people and governance skills.... that should be obvious from Bernanke's disastrous and ineffectual tenure.
4. Monetary policy is only necessary (and effective) because of sticky wages and prices. Wages and prices are not sticky over the long run, which is why monetary policy has little long term effect.
5. With the very near advent of unlimited 35 cent/hour skilled labor (thank you AI and robotics), discussion of monetary is the proverbial rearrangement of deck chairs (whether on the Titanic or Starship Enterprise remains to be seen.)
How will Helmsman Warsh deal with the current PCE situation? Perhaps seize on some recent fluctuations in gas prices to claim that we've turned the corner on inflation and that the current inflation is still a consequence of policy from 2020-2024?
"I could not care less what Kevin Warsh thinks about interest rates. Tell me what sort of goal he has for inflation and/or NGDP, and whether he supports level targeting or a “let bygones-be-bygones” approach that fails to stabilize NGDP. That will determine the path for interest rates".
The Fed’s mistake in 2021-22 was to “set rates at a level that it knew would dramatically overshoot the 4% pre-Covid trend line for NGDP.” A monetarist could argue that there was nothing the Fed could have done to prevent the inflation spike after the blowout in M2 from the Treasury’s $3 trillion deposit—more than 10% of gdp—in people’s checking accounts in 2q 2020.
I strongly disagree with that. The Fed has unlimited ability to reduce the monetary base, which would also reduce M2. It can always tighten policy; it simply choose not to do so. Indeed the Fed set rates at zero and was doing lots of QE.
The big mistake, however, was reneging on its promise to do average inflation targeting, to offset high inflation one year with below target inflation in future years.
Yes in theory. In practice the Fed flinched. It’s easy to understand why. How to explain that their mandate required reversing the administration’s fiscal policy?
Their mandate is stable prices and full employment, which shouldn't be hard to explain. Biden did not benefit from an overheated economy and high inflation.
It wouldn't really "reverse" fiscal policy, the public would still get the checks they coveted.
I’m intrigued by your point about the Fed itself being a determinant of r*. This makes a lot of sense from an MM framework since MP works through changes in E{NGDP}.
(1) Do you think that it mostly affects the supply or demand for loanable funds?
(2) What does that mean for the concept of monetary neutrality (even super neutrality) in the longer run?
—————————
Feel free to stop here! The next parts are more likely to be incoherent rambles.
I’m sympathetic to the notion money may not be neutral in the longer run if NGDP shocks are not normally distributed. E.g. I imagine that one business that faces normally distributed nominal revenue shocks would behave differently from another business that faces fairly consistent 4% revenue growth with little to no upside and a high risk of a downward negative revenue shock. I.e., a distribution of NGDP shocks skewed to the downside would encourage more risk-averse saving and less risky investment.
PS:
FYI Trump to Warsh: “I want Kevin to be totally independent. I want him to be independent and just do a great job. Don’t look at me, don’t look at anybody. Just do your own thing and do a great job,” he said.
In real terms it probably mostly affects the demand for loanable funds (by impacting investment). But even if money is neutral, policy affects inflation and hence the nominal natural rate of interest.
Hmmm…so you think the level of Japan’s RGDP is as high now as it would have been had the pursued a more effective MP in the 1990s?
I suppose the off-ramp (for me) would be if a central banks pursues credit policies (changing the composition of its balance sheet while holding the stance of MP as constant as the Fed did between April 2008 and October 2008–and probably even after; thinking of Bob Hetzel’s work here).
It seems a larger central bank balance sheet relative to commercial bank deposits would entail disintermediation of credit from the private to public sector and result in less efficient investment.
I would never suggest that these factors have precisely zero effect, but I suspect the impact on GDP would be too small to be noticeable. The Fed was mostly just buying back the government's debt, and paying for it with interest bearing bank reserves--which is close to a wash.
I concur it was swapping different types of government liabilities but I’m thinking along a different margin.
For example (and for simplicity), suppose households can only save via deposits with commercial banks. Banks back some deposits with central bank reserves and the rest is credit for the business and public sectors. The central bank provides a slice of that credit to back its reserves.
I concur it was swapping different types of government liabilities but I’m thinking along a different margin.
For example (and for simplicity), suppose households can only save via deposits with commercial banks. Banks back some deposits with central bank reserves and the rest is credit for the business and public sectors. The central bank provides a slice of that credit to back its reserves.
If at the margin, commercial banks backed all their deposits with reserves, then the central bank would be the sole arbiter of credit to the business and public sectors.
I’ve assume here no central-bank issued currency for simplicity.
While this is an extreme example at the margin a larger central bank balance sheet relative to extant deposits leads to more savings be allocated by a central bank relative to the private sector, which I strongly suspect would be far less economically efficient.
(Thinking about this issue more given Warsh’s objective to shrink the Fed’s balance sheet.)
I favor shrinking the balance sheet, but I doubt it has much effect on credit allocation. As long as banks have profitable loan opportunities, they should be able to access the necessary funds from one source or another. And due to FDIC, banks may be providing too much credit, relative to what is socially optimal.
That’s the problem with the Fed’s floor system in which it de facto pays a market-competitive IORB rate. Some FOMC participants see this as adhering to the Friedman rule and suggest that market-competitive IORB rates prevent banks from having to “economize on liquidity”. I’m less confident about the benefits.
Indeed a large balance sheet and chronically below-target inflation is likely why MMT gained such traction up through 2021.
As any economist should! But the story does fit Japan quite well. Said another way…what would an economy’s real growth look like if it fell into and remained in Krugman’s Expectations Trap for 30 years?
On the second point I might need to clarify: if MP can permanently induce a lower real r* via lower investment, does that not slow capital accumulation and labor productivity growth by extension? In other words, money might not be neutral in the long run.
It’s an MM explanation for sustained low growth low inflation outcomes that Keynesians would be liable to label secular stagnation.
I'm very skeptical of any claim that monetary policy affects real variables in the long run. In my view, it affects both nominal and real interest rates and the short run, and only nominal interest rates in the long run.
I read that Koyama review too. I've never been accused of being a glass half-full person, and I was dissatisfied. Although it said many sensible things, it also has a bet each way by endorsing RBC thinking about recessions, using bank failures, locust plagues and 'multiple causes' as the explanation for many recessions, including the Great Depression and Great Recession. Yes, he follows up with the point about 'firefighters and arsonists', but in all of the cases he cites, my guess is that monetary mismanagement is responsible for 90% of the harm. I guess one's disciples can become the most hardline zealots, Scott...(!)
Yes, I think that review put too much weight on real business cycles, at least for the modern period. But under the gold standard, real shocks were very important factors generating the business cycle--as they impacted the demand for gold and hence NGDP.
There are good arguments against NGDP targeting for Australia, but I don't believe those arguments apply to the US. For instance, he cites the 2021-23 inflation surge as a reason to do inflation targeting, when if fact the 2021-23 inflation surge is a powerful argument for NGDP level targeting. If we had been targeting the level of NGDP then the big inflation surge never would have occurred.
Contrary to what the post claims, NGDP targeting does not require the central bank to estimate what part of inflation is supply side, nor does it require stable productivity growth.
Australia's GDP figures are more volatile due to swings in the global commodity sector. I believe those swings primarily impact capital income, whereas it's actually the labor portion of NGDP that most needs to be stabilized. Even in the US the two can diverge, but generally they track each other pretty closely. For major commodity exporters, you would not wish to shrink the non-commodity sector of the economy merely because a global boom in commodities pushed iron, coal and gas prices up sharply.
In an extreme case like Kuwait or the UAE, NGDP targeting would be a very poor choice.
Your helmsman point is correct, and I think it goes deeper than most people are comfortable admitting. Part of why we resist it is that we want to believe someone competent is in control. The Fed serves that psychological function as much as an economic one.
Where NETs enters is not in challenging that conclusion but in identifying what distorts the policy layer sitting between the market signal and the institutional response.
Think of it like a physics measurement problem. The underlying physical reality does not change because your instrument is miscalibrated. The market prices things correctly in real time, regardless of how we measure it afterward. But when you build a policy tool calibrated to the wrong measurement, that tool interacts with the real economy and produces slightly wrong outcomes. In physics, a measurement error resets each time you take a new reading. In economics, it compounds. Each inflation error compounds with the next year's error. The miscalibration does not stay contained. It accumulates.
That is what a 1.5% annual drift in CPI does over fifty years. The market is not confused. The market is fine. The damage shows up in the policy apparatus built on top of that compounding error, in wages subdued over decades, in the growing gap between what the official numbers say and what people actually experience.
The Fed is not just a bad helmsman. It is a helmsman reading a map drawn to the wrong scale, and that scale error gets worse every year it goes uncorrected.
"This is where my steering the car down the road analogy comes up short. "
Not at all! I think your analogy works brilliantly. It makes perfect sense that the Fed has more control over the long term than the short term, just as a driver has more control over what they're going to be doing with the steering wheel long term (based on where they choose to go, and what the roads are like there) versus short term (dictated by the shape of the road they're already on).
The biggest error in economics is that banks loan out deposits. Not so. Deposits are the result of lending/investing. The proper policy to avoid a recession is the 1966 Interest Rate Adjustment Act.
You drain reserves while driving the banks out of the savings business. Lower FDIC limits back to 100,000 dollars.
There's been a flight to liquidity. Means-of-payment money has increased by over 1 trillion dollars since October 2025. The rate-of-change in monetary flows, the volume and velocity of money, is still accelerating.
> With the Iran war unleashing the biggest inflation surge
After reading about “helicopter drop” mental experiment to explain effects of nominal shocks on inflation, I must confess that I am completely confused what would be the expected effects of such a real shock.
Like, imagine we wake up one day, and discover that the world now has 2X less oil, for whatever reason. What happens with inflation, and why? Naively one would think that oil gets more expensive => stuff that needs oil (≈everything) gets more expensive => inflation. But isn’t this confusing changes in relative prices with changes in price level?
What should I read to understand this better? My current confused thinking:
If the real reduction of oil output is temporary, we probably expect zero changes — real economy is made of flows, rather than stocks, so temporary disruptions are small in the grand scheme of things, and, in the small scheme of things, real stocks and financial futures should paper over real shock.
If the real reduction is long term (affects flows, rather then stocks), then, duality, we expect prices to jump up immediately, even we do have physical storage for the current moment. This _probably_ should mechanically push up what we call inflation. My understanding is that there isn’t a objective way to _define_ inflation, the same way we define NGDP, there’s only a specific measurement: a cost of a fixed basket of goods of “typical” consumption. Given that prices change immediately, and re-balancing the basket takes time, the _index_ goes up.
Then, on top of the accounting problem of updating the basket, there’s probably some real friction as well, people spending more money on fuel than what they’d prefer, given the price level, because they, eg, planned a trip while the price was lower, running down their stock of money.
But over the medium term, it feels like we should see not the cost of basket going up, but its composition shifting, such that there’s less oil in real terms: the shift in _relative_ prices making oil dearer, and a shift in composition of basket, keeping the overall price level the same.
But something does not add up here: we do really have less oil, the world _is_ poorer in real terms, shouldn’t that somehow get reflected in the price level?
And then, yeah, there’s of course this whole steering the wheel thing, where presumably our prediction should be that, assuming central bank targets inflation, real shocks should not affect inflation at all, and rather effect a change in the position of levers used by the central bank for steering…
I like the way you think :-)
You are of course right that if there's a negative oil supply shock, then oil consumption has to drop also, and relative prices must and will adjust, i.e., the price of oil must and will go up relative to the wage rate. So what happens to the price level?
In principle, one could have a severe supply shock without any change to the price level, but that would require workers to accept lower wages. Theoretically, that's no problem, but getting 180 million people to accept lower wages is a practical impossibility ("downward nominal rigidity"). But if you persist and use monetary policy to prevent the nominal price of oil from rising, then you wind up with a recession and a lot of unemployment instead --- people lose their jobs and you reduce oil consumption that way. Ouch!
The only practical answer is to allow oil-related prices to rise (gasoline, things requiring a lot of oil input) while holding the wage rate constant. You may wind up with above-2% inflation until relative prices come into equilibrium. This is why many people (including, I think, Scott) would agree that a fixed 2% inflation target is a bad idea, and what you want instead (if you can't have NGDP targeting) is FAIT (flexible average inflation targeting) where you allow inflation to run above target during negative supply shocks, and below target during positive supply shocks.
-Ken
Yes, that nicely summarizes my view.
BTW, this issue is symmetrical, and thus the Fed should have generated below 2% inflation during 2023-24, when aggregate supply did well.
In your example of oil collapsing by 50%, it would put real strain on the economy through what I would call a demand compression sequence. Crude oil prices would skyrocket, and since demand for oil is inelastic, consumers and businesses would have to adjust their spending to offset the higher cost, cutting back on discretionary spending and investment across the board.
Normally, high prices would increase supply and resolve the issue over time. But a 50% supply collapse is most likely structural, meaning the high prices would persist rather than self-correct. That persistence is what makes this different from a typical supply disruption.
The result would be initially higher measured inflation, but the more important downstream effect is deflationary. As the broader economy contracts to accommodate permanently higher energy costs, spending shrinks, investment pulls back, and the overall price level follows downward. The 1 to 2 year outlook in this scenario is deflationary, not inflationary, even though the shock itself looked inflationary at the start.
It is worth noting this scenario describes a permanent structural collapse, which is not what we are seeing now. The current inflation surge is a risk premium on an active conflict, not a fundamental supply destruction event. Barring a dramatic escalation, I would expect prices to revert back toward trend, somewhere in the 0.3 to 0.5% monthly range, by the end of the year, even if the conflict remains active.
Scott,
1. I see you have shifted from a steering the ship analogy to a steering the car analogy.
2. Japan has no RGDP growth because high tax rates have caused average expected after tax returns on investment to be negative. Monetary policy can do nothing to fix that.
3. Warsh's view on rates and policy are probably much less important than his people and governance skills.... that should be obvious from Bernanke's disastrous and ineffectual tenure.
4. Monetary policy is only necessary (and effective) because of sticky wages and prices. Wages and prices are not sticky over the long run, which is why monetary policy has little long term effect.
5. With the very near advent of unlimited 35 cent/hour skilled labor (thank you AI and robotics), discussion of monetary is the proverbial rearrangement of deck chairs (whether on the Titanic or Starship Enterprise remains to be seen.)
I agree with 1, 2, 4, and 5.
#3 depends on whether people skills are used for a good or bad policy.
How will Helmsman Warsh deal with the current PCE situation? Perhaps seize on some recent fluctuations in gas prices to claim that we've turned the corner on inflation and that the current inflation is still a consequence of policy from 2020-2024?
Eventually, he'll have to face reality. Better now than later.
I don't think he's going to be able to fulfill his goal of cutting rates.
"I could not care less what Kevin Warsh thinks about interest rates. Tell me what sort of goal he has for inflation and/or NGDP, and whether he supports level targeting or a “let bygones-be-bygones” approach that fails to stabilize NGDP. That will determine the path for interest rates".
Fully agree with you!
Do you plan on reading Tyler G's book?
Not sure, I have a huge backlog of stuff to read. I'll see what others say about it. Does it have some new ideas?
Was hoping you would know that so i could make decision to read or not, Ha! For now i will pass on reading it.
Thanks for your response!
I wonder if interest on reserves has now become golden handcuffs.
if they stop paying them presumably all that money flows out and tries to find a new inflation hedge simultaneously driving inflation.
i guess they could step them down incrementally or smoothly but thats a tap they are opening slowly - that money still flows out.
what do they do to this huge stimulus, pull some other lever in a futile attempt to undo what they are doing at the window?
They can target interest rates during the transition.
Warsh can't say stuff like this. No way to know what he really thinks, not to mention what FOMC will actually do. Here we go!
The Fed’s mistake in 2021-22 was to “set rates at a level that it knew would dramatically overshoot the 4% pre-Covid trend line for NGDP.” A monetarist could argue that there was nothing the Fed could have done to prevent the inflation spike after the blowout in M2 from the Treasury’s $3 trillion deposit—more than 10% of gdp—in people’s checking accounts in 2q 2020.
I strongly disagree with that. The Fed has unlimited ability to reduce the monetary base, which would also reduce M2. It can always tighten policy; it simply choose not to do so. Indeed the Fed set rates at zero and was doing lots of QE.
The big mistake, however, was reneging on its promise to do average inflation targeting, to offset high inflation one year with below target inflation in future years.
Yes in theory. In practice the Fed flinched. It’s easy to understand why. How to explain that their mandate required reversing the administration’s fiscal policy?
Their mandate is stable prices and full employment, which shouldn't be hard to explain. Biden did not benefit from an overheated economy and high inflation.
It wouldn't really "reverse" fiscal policy, the public would still get the checks they coveted.
I’m intrigued by your point about the Fed itself being a determinant of r*. This makes a lot of sense from an MM framework since MP works through changes in E{NGDP}.
(1) Do you think that it mostly affects the supply or demand for loanable funds?
(2) What does that mean for the concept of monetary neutrality (even super neutrality) in the longer run?
—————————
Feel free to stop here! The next parts are more likely to be incoherent rambles.
I’m sympathetic to the notion money may not be neutral in the longer run if NGDP shocks are not normally distributed. E.g. I imagine that one business that faces normally distributed nominal revenue shocks would behave differently from another business that faces fairly consistent 4% revenue growth with little to no upside and a high risk of a downward negative revenue shock. I.e., a distribution of NGDP shocks skewed to the downside would encourage more risk-averse saving and less risky investment.
PS:
FYI Trump to Warsh: “I want Kevin to be totally independent. I want him to be independent and just do a great job. Don’t look at me, don’t look at anybody. Just do your own thing and do a great job,” he said.
VERY CONFUSING!!!
In real terms it probably mostly affects the demand for loanable funds (by impacting investment). But even if money is neutral, policy affects inflation and hence the nominal natural rate of interest.
Hmmm…so you think the level of Japan’s RGDP is as high now as it would have been had the pursued a more effective MP in the 1990s?
I suppose the off-ramp (for me) would be if a central banks pursues credit policies (changing the composition of its balance sheet while holding the stance of MP as constant as the Fed did between April 2008 and October 2008–and probably even after; thinking of Bob Hetzel’s work here).
It seems a larger central bank balance sheet relative to commercial bank deposits would entail disintermediation of credit from the private to public sector and result in less efficient investment.
I would never suggest that these factors have precisely zero effect, but I suspect the impact on GDP would be too small to be noticeable. The Fed was mostly just buying back the government's debt, and paying for it with interest bearing bank reserves--which is close to a wash.
I concur it was swapping different types of government liabilities but I’m thinking along a different margin.
For example (and for simplicity), suppose households can only save via deposits with commercial banks. Banks back some deposits with central bank reserves and the rest is credit for the business and public sectors. The central bank provides a slice of that credit to back its reserves.
I concur it was swapping different types of government liabilities but I’m thinking along a different margin.
For example (and for simplicity), suppose households can only save via deposits with commercial banks. Banks back some deposits with central bank reserves and the rest is credit for the business and public sectors. The central bank provides a slice of that credit to back its reserves.
If at the margin, commercial banks backed all their deposits with reserves, then the central bank would be the sole arbiter of credit to the business and public sectors.
I’ve assume here no central-bank issued currency for simplicity.
While this is an extreme example at the margin a larger central bank balance sheet relative to extant deposits leads to more savings be allocated by a central bank relative to the private sector, which I strongly suspect would be far less economically efficient.
(Thinking about this issue more given Warsh’s objective to shrink the Fed’s balance sheet.)
I favor shrinking the balance sheet, but I doubt it has much effect on credit allocation. As long as banks have profitable loan opportunities, they should be able to access the necessary funds from one source or another. And due to FDIC, banks may be providing too much credit, relative to what is socially optimal.
That’s the problem with the Fed’s floor system in which it de facto pays a market-competitive IORB rate. Some FOMC participants see this as adhering to the Friedman rule and suggest that market-competitive IORB rates prevent banks from having to “economize on liquidity”. I’m less confident about the benefits.
Indeed a large balance sheet and chronically below-target inflation is likely why MMT gained such traction up through 2021.
I completely agree.
As any economist should! But the story does fit Japan quite well. Said another way…what would an economy’s real growth look like if it fell into and remained in Krugman’s Expectations Trap for 30 years?
Because the Expectations Trap is a nominal shock, I would not expect any effect on growth after 30 years.
On the second point I might need to clarify: if MP can permanently induce a lower real r* via lower investment, does that not slow capital accumulation and labor productivity growth by extension? In other words, money might not be neutral in the long run.
It’s an MM explanation for sustained low growth low inflation outcomes that Keynesians would be liable to label secular stagnation.
I'm very skeptical of any claim that monetary policy affects real variables in the long run. In my view, it affects both nominal and real interest rates and the short run, and only nominal interest rates in the long run.
I read that Koyama review too. I've never been accused of being a glass half-full person, and I was dissatisfied. Although it said many sensible things, it also has a bet each way by endorsing RBC thinking about recessions, using bank failures, locust plagues and 'multiple causes' as the explanation for many recessions, including the Great Depression and Great Recession. Yes, he follows up with the point about 'firefighters and arsonists', but in all of the cases he cites, my guess is that monetary mismanagement is responsible for 90% of the harm. I guess one's disciples can become the most hardline zealots, Scott...(!)
Yes, I think that review put too much weight on real business cycles, at least for the modern period. But under the gold standard, real shocks were very important factors generating the business cycle--as they impacted the demand for gold and hence NGDP.
I'd be interested in your response to this blog Scott. https://markthegraph.blogspot.com/2026/05/inflation-targeting-vs-ngdp-targeting.html
There are good arguments against NGDP targeting for Australia, but I don't believe those arguments apply to the US. For instance, he cites the 2021-23 inflation surge as a reason to do inflation targeting, when if fact the 2021-23 inflation surge is a powerful argument for NGDP level targeting. If we had been targeting the level of NGDP then the big inflation surge never would have occurred.
Contrary to what the post claims, NGDP targeting does not require the central bank to estimate what part of inflation is supply side, nor does it require stable productivity growth.
What are the good arguments in the Australian case? Their former (now extinct) productivity? Or was that a more general point that I missed?
Australia's GDP figures are more volatile due to swings in the global commodity sector. I believe those swings primarily impact capital income, whereas it's actually the labor portion of NGDP that most needs to be stabilized. Even in the US the two can diverge, but generally they track each other pretty closely. For major commodity exporters, you would not wish to shrink the non-commodity sector of the economy merely because a global boom in commodities pushed iron, coal and gas prices up sharply.
In an extreme case like Kuwait or the UAE, NGDP targeting would be a very poor choice.
Thank you!
Thanks!
Your helmsman point is correct, and I think it goes deeper than most people are comfortable admitting. Part of why we resist it is that we want to believe someone competent is in control. The Fed serves that psychological function as much as an economic one.
Where NETs enters is not in challenging that conclusion but in identifying what distorts the policy layer sitting between the market signal and the institutional response.
Think of it like a physics measurement problem. The underlying physical reality does not change because your instrument is miscalibrated. The market prices things correctly in real time, regardless of how we measure it afterward. But when you build a policy tool calibrated to the wrong measurement, that tool interacts with the real economy and produces slightly wrong outcomes. In physics, a measurement error resets each time you take a new reading. In economics, it compounds. Each inflation error compounds with the next year's error. The miscalibration does not stay contained. It accumulates.
That is what a 1.5% annual drift in CPI does over fifty years. The market is not confused. The market is fine. The damage shows up in the policy apparatus built on top of that compounding error, in wages subdued over decades, in the growing gap between what the official numbers say and what people actually experience.
The Fed is not just a bad helmsman. It is a helmsman reading a map drawn to the wrong scale, and that scale error gets worse every year it goes uncorrected.
I have documented the methodology, the convergence, and the falsifiability criteria here if you want to look further: https://www.nets-project.com/p/nets-core-claim-the-15-cpi-drift?r=5rrs9a
"This is where my steering the car down the road analogy comes up short. "
Not at all! I think your analogy works brilliantly. It makes perfect sense that the Fed has more control over the long term than the short term, just as a driver has more control over what they're going to be doing with the steering wheel long term (based on where they choose to go, and what the roads are like there) versus short term (dictated by the shape of the road they're already on).
If N-gDp pops, as several sources have indicated, it's time to tighten.
The biggest error in economics is that banks loan out deposits. Not so. Deposits are the result of lending/investing. The proper policy to avoid a recession is the 1966 Interest Rate Adjustment Act.
You drain reserves while driving the banks out of the savings business. Lower FDIC limits back to 100,000 dollars.
There's been a flight to liquidity. Means-of-payment money has increased by over 1 trillion dollars since October 2025. The rate-of-change in monetary flows, the volume and velocity of money, is still accelerating.
I've heard Goodspeed talk on some podcasts, and it made me want to pick up his book. At a minimum, he's good with metaphors.
Works in Progress review is here: https://worksinprogress.co/issue/review-recession-the-real-reasons-economies-shrink-and-what-to-do-about-it/