FRBSF Economic Letter
99-21; July 2, 1999
Supply Shocks and the Conduct of Monetary Policy
The U.S. economy has performed remarkably well over the last few years.
Real output has grown at a pace that is noticeably above average, while
inflation has declined somewhat. These--and related--developments have
led to an increase in uncertainty about the economy's long-run growth
In this Letter, I argue that increased uncertainty about the
long-run growth rate of the economy means that one should not rely as
much on some of the traditional ways of gauging the extent of inflationary
pressure in the economy. Specifically, I argue that it may be unwise to
rely too heavily on measures such as the "sustainable" rate
of output growth or (especially) the level of "potential" output
during a period in which the economy appears to have been hit by a positive
supply shock of unknown magnitude and duration. A better strategy may
be to pay more attention to a measure such as nominal GDP growth.
The evidence for a supply shock...
Generally speaking, the rapid growth of the last few years has surprised
economic forecasters; for most of this period, they have been projecting
that the economy will slow down. Thus, in December 1997, the consensus
Blue Chip forecast called for real GDP to grow at a 2.2% rate over the
four quarters of 1998, while actual growth came in at 4.2%. And the 3.8%
growth over the previous year was almost twice the 2% growth predicted
by the consensus in December 1996. The behavior of inflation has been
a surprise as well. Not only did inflation come in lower than expected,
but the inflation rate actually declined. For instance, the core CPI (which
excludes food and energy prices) rose at a 3.0% rate in 1995 but at a
2.2% rate over the first four months of this year.
This pattern of surprises suggests that the economy is experiencing a
positive supply shock. The likely source of such a shock is the technology
sector, especially information processing and communications technology.
The explosive growth in the use of computers over this decade hardly needs
to be remarked upon; computers seem to have transformed everything from
trading stocks to designing airplanes. Also commonplace is the observation
that this remarkable growth has been accompanied by steadily falling computer
It is not unreasonable to expect that the enormous investment that firms
have made in information processing technology over this period would
have a beneficial impact on the economy's productivity. Yet until recently,
such evidence has been hard to find. For example, until a few years ago,
data since the early 1970s looked consistent with a long-term (or trend)
productivity growth rate of around 1%. More recently, the growth rate
of productivity has picked up. For instance, output per hour in the nonfarm
sector has grown by an average of 2.3% per year over the 1996-1998 period.
...and some implications
While there is now more evidence to suggest that the average growth rate
of productivity has gone up, it is still hard to tell by how much, or
for how long. Much (if not all) of the recent pickup in productivity growth
could be temporary; that is, it could be the economy's usual cyclical
response to high demand. Or most of it could be the result of increased
use of computers. And even in this case, the resulting boost to productivity
growth could be short-lived, or it could be with us for a long time.
Uncertainty about the average (or trend) growth rate of productivity
translates into uncertainty about the trend growth rate of output. Uncertainty
about trend output, in turn, poses a problem for those who would rely
on such measures to determine the appropriate stance of policy. Suppose,
for instance, that the trend rate of productivity goes up, perhaps because
of the increasing use of computers. The increase in the trend productivity
growth rate is unlikely to be noticed at first, however, the higher output
growth will be obvious to all. Policymakers who are accustomed to output
growth rates from the regime before productivity accelerated could well
interpret the faster growth as evidence of excess demand and move to a
tighter policy as a result.
Reliance on measures such as the "output gap" would be even
more problematic, since this measure requires knowledge of the level of
potential or trend output in the economy. (Taylor 1993 recommends that
policymakers base the stance of monetary policy on a measure of the output
gap and a target rate of inflation.) An underestimate of the productivity
trend would lead to a measured output gap that would keep growing over
time, even if the true gap were zero. Since the output gap is meant to
measure the cyclical or temporary component of output, policymakers would
interpret the growth in the measured gap as evidence of an overheating
economy and would be likely to keep tightening policy in a mistaken attempt
to reduce the gap to zero.
How much of a mistake could one actually make? While there is no way
to provide a definitive answer, some recent work by Orphanides (1999)
provides one measure of the potential for such a mistake. Orphanides looks
at the conduct of policy over a 30-year period ending in 1993. Of particular
interest to us is his analysis of policy during the 1960s and the 1970s,
a period during which the rate of productivity growth slowed dramatically.
This slowdown seems to have persisted till the end of Orphanides's sample
period; but when it began, it was hard to judge how persistent it would
be. Orphanides finds that it took a long time for economists to determine
that the slowdown would be long-lived, and that they persisted with old
estimates of the trend well into the 1970s. Thus, real-time estimates
of the output gap showed an economy that appeared to be substantially
below trend in the early and, especially, the mid-1970s. He goes on to
show that if policymakers had based policy on a measure of the output
gap derived from then-available measures of the trend level of output,
they would have generated a funds rate path close to the actual path during
the 1970s (even if they also had been responding to the rising inflation
rate). In other words, they would have generated a monetary policy that
was similar to the actual policy over this period. Thus, a mistake about
the trend growth rate could be large enough to take us from the low inflation
rate of the 1960s to the high inflation rate of the 1970s.
An alternative guide
The possibility of such mistakes in an environment of increased uncertainty
about the growth rate of either actual or potential real output suggests
that one should pay less attention to policy rules or strategies that
rely upon such measures, and pay more attention to rules or strategies
that are not affected by such problems. It seems more useful, in particular,
to pay more attention to nominal GDP growth.
The recommendation to pay attention to nominal GDP growth given the likelihood
of a supply shock echoes similar recommendations in the past. Hall (1983)
argues for a nominal GDP target on the grounds that it can be hard to
distinguish cyclical from structural changes. According to McCallum (1988,
pp. 174-175), the "..most fundamental.." reason for paying attention
to nominal GDP is that "...the macroeconomics profession has not
produced a reliable quantitative (or even qualitative) model of Phillips-curve
or aggregate-supply behavior. In other words, there is very little basis
for any predictions concerning the way in which quarterly or annual changes
in nominal GNP will be divided between real output growth and inflation."
The advantage of such a strategy in the current environment is that one
does not end up making a big bet on a particular rate of real output or
productivity growth. A nominal GDP growth target of 5%, for example, would
be enough to prevent deflation for productivity growth rates as high as
4% (assuming that the labor force continues to grow at roughly 1%). And
if the productivity growth surge turned out to be temporary, and productivity
growth headed back to 1%, we would have no more than 3% inflation. Thus,
a strategy of responding to nominal GDP growth appears likely to be robust
to (a reasonable amount of) uncertainty about long-run real output trends.
It is instructive to see how a policy that responds to nominal GDP growth
would compare to one that puts most or all of the weight on real GDP in
an environment where there has been an unperceived increase in productivity
growth. As discussed above, a policymaker following the latter strategy
would be likely to read the resulting increase in output growth as suggesting
a need for tighter policy. But this response ignores the behavior of inflation,
which is likely to fall as a result of the productivity increase. Looking
at nominal GDP automatically internalizes both effects, and keeps policy
from tightening too much.
Higher productivity growth could lead to an upward shift in demand as
well. For instance, firms might like to increase investment substantially
in order to attain a higher desired capital stock quickly. Or households
might wish to increase consumption, in response to a perceived increase
in permanent (or long-run) income, even before the expected increase in
the economy's productive capacity actually takes place. Policymakers could
easily respond to the resulting increase in aggregate demand by tightening
This way of responding to nominal GDP growth is similar to the way policymakers
responded to money growth before velocity shifts became a problem. The
most well-known example is during the period 1979-1982, when fast money
growth, for instance, was interpreted as evidence that the funds rate
was being held too low. So the suggestion of monitoring nominal GDP growth
is not that radical; it is one way of responding to the loss of indicator
variables (i.e., the monetary aggregates) caused by the recent instability
The existence of a supply shock makes it hard to judge inflationary risk
by looking at real output growth, since such shocks tend to change the
output-inflation mix in the economy. One response that is robust to the
resulting uncertainty is to pay more attention to the growth in nominal
GDP (or spending). As supply shocks change output and inflation growth
in opposite directions, they will obviously have a smaller impact on nominal
Keeping an eye on spending would allow policymakers to keep inflation
within reasonable bounds, even if they were unsure about the economy's
potential growth rate. Using nominal GDP in this way--as an indicator--
is similar to the way that monetary aggregates were employed in the past,
before velocity shifts made them hard to interpret.
Hall, Robert E. 1983. "Macroeconomic Policy under Structural Change."
In Industrial Change and Public Policy. Federal Reserve Bank
of Kansas City.
McCallum, Bennett T. 1988. "Robustness Properties of a Rule for
Monetary Policy." Carnegie-Rochester Conference Series on Public
Policy 29, pp. 173-204.
Orphanides, Athanasios. 1999. "The Quest for Prosperity without
Inflation." Mimeo. Board of Governors of the Federal Reserve System.
Taylor, John B. 1993. "Discretion versus Policy Rules in Practice."
Carnegie-Rochester Conference Series on Public Policy 39, pp.
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