One economic indicator is signaling that inflation is not at all conquered and that the Federal Reserve’s monetary policy is still far too loose.
The statistic in question is nominal gross domestic product, or NGDP, growth — that is, the growth of economic output before adjusting for inflation.
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It stands in contrast to a range of other signs inflation is receding: The inflation rate is falling, inflation expectations are dropping, wage growth is moderating, job openings are declining, and investors now expect that the Fed’s next move will be to cut its interest rate target.
In the third quarter, NGDP surged, growing at nearly a 9% annualized rate — the fastest growth in 20 years, setting aside the massive numbers posted during the reopening from the pandemic.
NGDP has been identified as an important signal of how hot the economy is running by many monetary policy experts, including former Fed Chairman Ben Bernanke.
It’s favored because it is a measure of total spending across the economy. Rapid growth suggests that people are spending freely. In the absence of a sudden massive surge in productivity and/or labor force growth, some of that excess spending is going to show up as inflation. As an example, if inflation were running at the Fed's target of 2% and NGDP were growing at 9%, that would mean that real economic growth was 7%, an explosive number that strains credibility. More likely, all that spending is translating into higher inflation.
The economic consultant Joseph Carson noted in a recent analysis published by Haver Analytics that the past three months of NGDP growth have been the strongest since the mid-1980s, before the “Great Moderation” that led to three decades of low and stable inflation.
Carson told the Washington Examiner that the fast growth of NGDP should lead the Fed to pursue more monetary policy tightening, a massive course correction given that investors now expect the Fed to start cutting rates as soon as March.
“Conditions are still telling them that the risk is more inflation rather than less,” he said.
In fact, monetary policy is the loosest it has been since 1997, according to a gauge maintained by the Mercatus Center at George Mason University based on the gap between expected and actual NGDP growth.
The metric shows that the economy “is warmer than many believe,” said David Beckworth, the Mercatus economist who constructed it.
On the other hand, there are reasons to believe that the signal from NGDP growth is less salient than all the signs that inflation is falling.
The first is simply that NGDP growth could moderate quickly. The latest NGDP data are from the third quarter, which ended in September. It’s quite possible that spending has already slowed dramatically since then, and indeed, expectations for fourth-quarter growth are significantly lower.
A second is that NGDP might simply be mismeasured. Notably, NGDP has diverged this year from nominal gross domestic income, or NGDI, which is a measure of output based not on total spending but on total incomes across the economy. In theory, the two measures should be equal. In practice, NGDI grew just 2.9% through the first three quarters of this year, versus 4.7% for NGDP.
Still, it is possible to explain away each of those mitigating factors. For example, consumer spending, a major component of GDP, was resilient in October, suggesting it is not dramatically retrenching heading into the winter. And the lower NGDI number is explained partly by the fact that the Fed’s profits have gone sharply negative in recent months as it has raised interest rates. That has subtracted from the income measure.
As for other signs the economy is running too hot besides NGDP, Carson noted stocks — the Dow Jones Industrial Average has surged nearly 10% in the past six months — and the unemployment rate, which, at 3.7%, is very low by historical standards, lower than any point between 1970 and 2019. In most years, Carson said, the Fed would be looking to raise rates in those circumstances.
It’s worth noting, too, that falling inflation is no guarantee that price pressures will abate. One precedent that surely is weighing on the minds of Federal Reserve officials is that of the early 1970s, when inflation was brought down from above 6% to below 3% only for it to then soar in the next few years to above 12%.
The circumstances are different today, not least because Fed officials are intent on avoiding the same mistakes that were made in the 1970s.
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In the end, NGDP growth is just one signal among many. And the fact that it was running hot in the third quarter is perhaps not too hard to reconcile with the bulk of the other data that show that inflation is still high, even if it is coming down quickly to end the year. The majority of the data are not “showing a collapse … they’re showing a softening,” noted Beckworth.
Still, it is a key metric to watch. Another strong NGDP number for the fourth quarter, to be released on Jan. 26, would signal that the economy is hotter than realized, Beckworth said.