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Bernanke Capitulates, Launches De Facto Nominal GDP Target


The only way the unemployment rate can get back to 6.5% is to close the output gap, which remains extremely wide.

Make no mistake about it, this is a de facto nominal GDP target. The only way the unemployment rate can get back to 6.5%, which is in fact below what some economists view as full employment, is to close the output gap which remains extremely wide.

In that same piece I noted that while a NGDP target was mostly a "fringe" economist idea, Goldman Sachs' (NYSE:GS) economist Jan Hatzius brought it into mainstream thinking in a report titled The Case for a Nominal GDP Level Target that he published in October 2011. Hatzius does a good job of laying out the framework for how a NGDP target would work.

We believe that the best way for the Federal Open Market Committee (FOMC) to deliver significant additional easing would be to target a nominal GDP path such as the one shown in Exhibit 1, indicating that it will use additional asset purchases-and all other available policy instruments-to ensure that actual nominal GDP reverts to trend over the medium term.

The specific path in Exhibit 1 is calculated as the level of nominal GDP in 2007 extrapolated forward at a rate of 4.5% per year. We can think of this number as the sum of real potential GDP growth of 2.5% and inflation as measured by the GDP deflator of about 2%.

Here's the problem.

During the recession that followed the financial crisis, nominal GDP went negative for four consecutive quarters, which had not happened in the post-WW II era. As you can see by Hatzius' chart, this has put a massive dent in the output gap. The current output gap is just over $17 trillion vs. today's NGDP of 15.8 trillion, yielding a deficit of 7.6%. The regression analysis on Bloomberg shows the current NGDP at nearly two standard deviations below the 20-year trend line.

The current run rate of nominal GDP growth is 4.0%, and Bernanke's implied growth rate, with a targeted 2.0-2.5% inflation rate, would equate to an NGDP growth rate of 4.5% to 5.0%. To put those numbers in historical context, the average annual NGDP growth rate since 2002 is 4.0%, and since 1992 it averaged 4.7%.

If you run a regression line to extrapolate output gaps in the future, you will find that in 2015, which was the Fed's previous target for ending accommodative policy trend NGDP should be at $19.6 trillion. In order to close that gap, NGDP would have to grow at a compound annual growth rate (CAGR) of 7.0%, which is virtually impossible given a 2.5% rate of inflation. To put that number in context in 2006 during the height of the credit bubble NGDP was growing at 6.5%. By 2020 trend NGDP is 24.7 trillion, a level that would be reached if the economy were to grow at a 5.6% CAGR, almost 100bps above the 20-year average. If the economy avoids any significant disruptions and continues to grow at 4.0%, the output gap might be closed sometime between 2020 and 2025.

If Bernanke intends to be easy until the economy reaches full employment and full employment won't be achieved until we close the output gap then it's not out of the realm of possibility to assume this regime of crisis level monetary policy may well last for another decade.
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