Lael Brainard on monetary policy

To understand how monetary policy went off course, it might help to look at Lael Brainard’s recent speech on monetary policy. Here is an excerpt:

Inflation in the United States and many countries around the world is very high (figure 1). While both demand and supply are contributing to high inflation, it is the relative inelasticity of supply in key sectors that most clearly distinguishes the pandemic- and war-affected period of the past three years from the preceding 30 years of the Great Moderation. Interestingly, inflation is broadly higher throughout much of the global economy, and even jurisdictions that began raising rates forcefully in 2021 have not stemmed the global inflationary tide.

In the United States, as a result of significant fiscal and monetary support, the level of private domestic final purchases recovered extremely rapidly in 2020 and 2021 to levels consistent with the pre-pandemic trend before moving below trend in 2022 (figure 2). Although demand came in near the pre-pandemic trend on an aggregate level, the pandemic induced a shift in composition that concentrated large increases in demand in certain sectors where the supply response was constrained.

To keep inflation at 2%, the Fed needs to keep growth in demand at roughly 3.5%/year in the long run.  Since 2019, nominal demand has risen by a total of about 8% more than the growth rate consistent with the Fed’s 2% inflation target, and PCE inflation has also overshot its target by roughly 8% over the past three years.  Thus almost all of the excess inflation is demand side.

So how does Brainard reach the opposite conclusion?  She links to a figure showing growth in real spending, which she uses as an indicator of aggregate demand.  It isn’t.  It is nominal spending that represents demand, not real spending.  In 2008, Zimbabwe saw an astronomical increase in nominal spending, even as real GDP declined.  By Brainard’s criterion, there was no problem with excess demand in Zimbabwe, as real spending was falling at the time.

It isn’t just Brainard; I’ve seen many other economists confuse nominal and real spending.  Real spending reflects the interaction of supply and demand shocks and is an unreliable indicator of whether there is excess demand in the economy. A positive supply shock will boost real spending without impacting the aggregate demand curve at all.  It’s the macroeconomic equivalent of conflating oil consumption and oil demand.

Brainard discusses the fact that central bankers traditionally tried to look past energy supply shocks, assuming that their effects on inflation were transitory.  She then suggests:

Although these tenets of monetary policy sound relatively straightforward in theory, they are challenging to assess and implement in practice. It is difficult to assess potential output and the output gap in real time, as has been extensively documented by research.

This is correct and is the reason why the Fed should completely ignore the output gap.  Instead, policymakers should focus like a laser on promoting slow and steady growth in nominal spending.  If they do so, the economy will stay relatively close to its natural rate.  But they should not try to figure out the natural rate of output, which (as Brainard rightly suggests) is impossible to determine in real time.

So what causes so many respected economists to conflate real spending and “demand”?  I blame Phillips Curve models, particularly the view that causation runs from strong real economic growth to high inflation. 

Milton Friedman had a much better interpretation.  Positive nominal shocks have real effects in the short run, which explains the negative relationship between inflation and unemployment seen in the Phillips Curve.  Output adjusts in the long run, and the economy goes back to the natural rate, even if inflation remains elevated.  In that case, the observation that real output is near the natural rate tells us next to nothing about whether the economy has experienced excess demand.

PS.  Brainard’s graph refers to “real final sales”, not real GDP.  But while those two variables are slightly different in an open economy, Neither variable measures anything close to “demand”.  The slight difference between the two in no way changes the conclusion that only nominal variables can adequately measure aggregate demand conditions.  

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