With Stubborn Inflation, What Should the Fed's Target Be? (With David Beckworth)

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders. 

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, Liz Ann, this week we got the much-anticipated March CPI data, and I'm guessing that's one of the main things on your radar right now. Why don't you start out with your reaction to it?

LIZ ANN: Yeah, I'm guessing it's on your radar and pretty much everybody's radar right now. It was obviously hotter than expected. For those who didn't see, the headline CPI rose 0.4. It was actually 0.38 to be exact, but it rounded to 0.4, and that put the year-over-year gain at 3.5%. And then the core CPI, which Xs out food and energy, was up 0.36, which again, rounds to 0.4 month-over-month, and that translates into a 3.8% year-over-year gain. You had big moves up—housing, clothing, transportation services, those were the categories that contributed most of the upside surprise to the core reading relative to expectations. And we saw the reaction very quickly in the equity market and obviously also in the bond market. 

So I'll turn to you, Kathy. What are your thoughts in terms of the bond market's reaction, Treasury yields, and then expectations for Fed policy?

KATHY: Yeah, the bond market has pretty much slammed the door closed on a June rate cut. Two-year yields jumped, and that's probably the most sensitive to shifting expectations about what the Fed will do. So that was a big move, and it's pulled yields up across the curve. Ten-year hit 4.50 again for the first time in quite some time.

I think the interesting thing to me is, you know, clearly this has got to be a disappointment to the Fed, to policymakers who've been hoping to see these numbers come down further. We have had, you know, very good inflation trend over the last couple of years. It's down substantially. And this one, what was interesting to me is a lot of it was driven by the transportation services. It's auto insurance and things like that. And you sit there, and you go, well, A, I'm not smart enough to know exactly what's driving the auto insurance costs up so much. I know cars are more expensive. Fixing them is more expensive. But why such outsized gains in that particular category are occurring, and what Fed policy can do about that. So I guess you can keep policy tight enough to squelch demand for cars, and maybe that will bring down the insurance rates, but it's kind of a question in my mind. If I'm sitting at the Fed, I'm looking at the breakdown of these numbers, I'm kind of like, "You know, I'm not really sure what we can do," but bottom line is they're going to have to continue to be patient. Maybe we're only going to get one or two rate cuts this year, maybe none. They'll wait until the numbers improve, and keep in mind, CPI is not what they target. They target the core PCE, but nonetheless, the numbers aren't going in the right direction, and that has to keep them on hold.

LIZ ANN: Rightly so. There are economists now in a short span of time after the CPI release that do the mapping of components of CPI into PCE. PPI, which comes out in a couple of days or tomorrow maybe, there's also components that map to the Fed's preferred measure of PCE. So we don't have all the data, but one of the estimates I saw from, I think, a Bloomberg economist, was that it suggests a 0.3 month-over-month gain in in core PCE. Even though PCE has been running cooler than CPI, that would still keep it probably elevated enough to keep the door slammed on a June cut. Also, interestingly, Kathy, you mentioned the auto insurance rates. And shame on me, I don't remember the podcast nor the guest because it was a while ago, but the guest was an expert in this area and was talking about some of the reasons why auto insurance rates have gone up. And there are more accidents, apparently. There's less fatalities, because cars are safer. And a lot of it has to do with all the bells and whistles in cars, and combine that with people on their phones, greater distractions, whether it's the technology you unfortunately keep in your hands or the technology in the car leads to more distractions, and that could be a component in why rates are going up. And back to your point, the Fed can't do anything about that.

KATHY: Yeah, maybe they can encourage people to just not talk on the phone while they're driving or not play with all the gadgets in the car. But yeah, it just puts them in a pickle because they can't ease when inflation's running too high …

LIZ ANN: Right.

KATHY: … and not showing signs of coming down. On the other hand, keeping the fed funds rate at 5.5% probably isn't going to influence a lot of the components that are pushing higher. So gets to be a real dilemma, but the easiest thing for them to do, and probably the right thing for them to do, is stand pat until the time is right. And I think that's, yeah, that's where we are, and I will say anecdotally, I love that you went out to two decimal points on the CPI because I think we're going to probably get to the point where we're doing four and five decimal points to try to parse some meaning out of these numbers. But this is where we are. 

LIZ ANN: This is where we are, exactly. 

So Kathy, you are having a conversation with our guest this week. So tell us a little about him.

KATHY: Yeah, today I'm speaking with David Beckworth. He's a senior research fellow at the Mercatus Center at George Mason University and a former international economist at the U.S. Department of the Treasury. He's the author of Boom and Bust Banking: The Causes and Cures of the Great Recession.

His research is very interesting, which is why I invited him to be a guest. He focuses on monetary policy, and his work is cited by Wall Street Journal, Financial Times, New York Times, Bloomberg, Businessweek, Economist. And he has advised congressional staffers on monetary policy and has written for Barron's, Investors' Business Daily, New Republic, Atlantic, National Review, and he hosts his own weekly podcast, Macro Musings, and we have a link to his show in the notes. And his focus is on monetary policy, and he's been a big advocate of the central banks targeting nominal GDP. So that's kind of the basis of our conversation, and I think people will find it very interesting.

So David, thanks for being here today.

DAVID BECKWORTH: Well, thank you for having me on your show.

KATHY: I know you as an advocate for nominal GDP targeting for central banks. As I'm sure you'll get into, some real benefits, but it hasn't been widely adopted. In fact, I think I remember reading an article almost a decade ago where this was advocated, and yet we haven't really seen central banks move in that direction. In fact, maybe they've moved in the opposite direction over the last decade or so. So I just want to explore that topic a bit and get your thoughts and what you see as the pros and cons of it, and what's going on in the real world of central bank policy. So maybe let's just start out, explain nominal GDP targeting to me.

DAVID: So nominal GDP targeting is an unfortunate set of words to describe an approach to monetary policy, but it is the technical term. But the basic idea is instead of targeting the price level or inflation, which is a measure of change in the price level, target total dollar spending in the economy. So those two are closely related. The amount of spending is going to affect the inflation rate.

But the inflation rate can reflect any number of things. It can reflect supply shocks, cost shocks, as well as spending or demand shocks. And the basic idea behind nominal GDP targeting is to really kind of laser-like focus the Fed's attention on demand, on spending. So nominal GDP targeting is an approach. Let's focus on aggregate demand, total demand in the economy. And we do that by looking at nominal GDP.

Now there is a flip side to this, and depending on who you are speaking to, you may want to take this other approach. So for every dollar spent, which I just described the spending side, there's a dollar earned. And so this means that if we stabilize total spending in dollar terms, we're also stabilizing total dollars earned or income, nominal income. So this has also been called nominal income targeting, and this actually goes back to the 1980s when we were looking for a nominal anchor back then. We went off of Bretton Woods. Money supply targeting wasn't working. So a number of prominent academic economists back then were advocating this, and it kind of fell out of favor. We kind of forgot about it because inflation targeting took hold. But back then it was called nominal income targeting. And what you referenced, Kathy, right after the great financial crisis when it was really popular again, most of the advocates were calling it nominal GDP targeting. But from a purely, like, accounting perspective, they're equivalent. So that's the basic idea, stabilized total spending or alternatively stabilized total sales in dollar terms.

KATHY: So how would it have been used, say, during the pandemic? So let's get kind of what would real life have looked like during and after the pandemic if the Fed had used this as a tool instead of the tools that it did use?

DAVID: OK, that's a great question. And I think one way to answer this is to go and look at what the Fed did and then provide a contrast. So you know, part of the big debate or maybe some of the chagrin looking back is we got it wrong on our inflation calls, right? We thought inflation was going to be low in 2021—at least I did, and the Fed and most forecasters did—and when in fact it did not. The calls for transitory inflation were driven by this idea that there'd be these temporary, largely supply-driven shocks.

But in real time, it's hard to know what's driving inflation. There's those supply-side shocks, which were there, but also the demand side. And so in real time, it's kind of hard to kind of tease out. The Fed should only respond, we believe, to demand-side shocks, not supply-side shocks. Because supply-side shocks are things that affect the fundamental side of the economy that the Fed really doesn't have any meaningful control over. So there can be temporary supply-side shocks, like, again, oil prices, or the ports closing down temporarily, or people not working, so there's temporary disturbances. There can also be permanent ones: People leaving the labor force permanently, or the productivity growth permanently goes up. Those are things on the real side that inflation can change because of them, but it's not something the Fed can meaningfully address, particularly in real time. It simply does not know enough. The other form of inflation is demand driven, and that's what we what we focus on nominal GDP. So 2021, there was some uncertainty as to what was driving inflation. I think that contributed to some of the confusion, on my part, I think, and many others as well. And how would nominal GDP targeting have been different? Well, if you had looked at a forecast for nominal GDP targeting, say in early 2021, most of the forecasts were showing that nominal GDP targeting, or the total dollar size of the economy, was going to probably grow above its pre-pandemic trend path by the last part of the year. Now there were some revisions to the nominal GDP data, which is one of the issues. We can come back and talk about that later. So in real time, it was a little tricky exactly when that would be. But there was a paper by a guy named Evan Koenig, used to be at the Dallas Fed, for example, and he's an advocate of nominal GDP targeting. Still is, but he's no longer at the Dallas Fed. And he had this paper there, it's on their website, that showed, if you take, I believe it was Blue Chip Forecast, and you look at their forecast, the dollar size, the level amount of nominal GDP, it'd be well above the pre-pandemic trend path. So how would it have been different? Well, the Fed would have allowed the rapid catch-up but would have tightened policy sooner. So it would have looked at the dollar size of the economy as opposed to having this eyes on inflation and having great uncertainty—is this inflation supply-side driven, is it demand driven? Even today, like what percent of inflation that's left above the target is demand versus supply? And what nominal GDP targeting does is it relieves the threat of that burden. It can effectively ignore inflation in the short run and focus on demand. Now over the medium run, it still cares about inflation because the trend path of inflation is driven by the amount of money and its use in the economy relative to the supply.

But I believe in 2021, had the Fed been looking at forecast nominal GDP, it would have been a little more pre-emptive in its tightening the monetary policy.

KATHY: So does the central bank have to assume a certain trend level in nominal GDP, and if it does, to target it, how does it deal with changes in that trend? Or doesn't it?

DAVID: No, it does. So most proposals that have been called for by prominent people typically acknowledge that potential real GDP will change. So nominal GDP, as you know, and your listeners know, you can think of it as both real GDP and inflation all in one, but the beauty of nominal GDP is you don't try to divide the two. You just observe what you observe, the dollars spending in the economy.

But within that, it's true that real GDP is a big component of that. And that does change. It's definitely not static. So many advocates would say you would need to gradually change that level target or that path, which is I think what you're getting at. And I think the easiest way to do that would be to look at some consensus forecast, and it would also be very gradual. It would never be like a big sudden change, unless something horrible would happen, a nuclear war would. If we're having that conversation, then nominal GDP targeting is not really that important. 

KATHY: Let's hope we're not having that conversation. Yeah.

DAVID: Right. So you do have to update your target gradually, eventually. But even if this is like a baseline, you could have drawn a trendline because this period was so short, because we're talking about just a few years where we went below the trendline and went above. And maybe by way of contrast or comparison, 2008 nominal GDP collapsed way below its trend path, and it never fully recovered. Now, eventually, I would say you don't want to go back to where it was 2008 because eventually people's plans change, contracts get modified, expectations are updated. But in the year or two after that collapse, it definitely was pain felt. In fact, another way to think through why this matters, if you don't return to that trend path, you don't return to where people thought their nominal incomes would be. 

Mortgages are harder to service. Financial contracts are harder to service. All of our debt is in nominal dollar terms. In some sense, the real economy is nominal, and at least in the short term, that's what matters. And so there's this other argument that's been made for nominal GDP targeting more recently that's a financial stability argument. But I think in the context of the pandemic, simply drawing like a straight line probably would have been good enough. I think we're now beyond straight-line drawing exercises, but just as an example, if you were to draw a straight line, right now the dollar size of the economy is close to $2 trillion higher than the trend path that would have grown. Now, I don't think we should treat that as the gospel anymore. I do think that gap is actually smaller because people have updated their expectations, but yeah, you would want to update, have some forecast of potential real GDP, and then you also want to kind of forecast and add in the 2% inflation target. And just to be clear, so this is not confusing, you want a nominal GDP target, but you implicitly also kind of bake in or put in what you think inflation should be over the medium to long run. So I would put in 2% plus whatever my estimate of what potential real GDP growth is going be over some period.

KATHY: So this brings to mind to me what's going on in Europe right now. So we had a very slow recovery after the great financial crisis, as you just noted, because we really didn't allow the economy to grow probably as quickly as it could have. And I look at where the Eurozone is right now, and they're having a very slow recovery from the pandemic.

Would nominal GDP targeting mean that they would be easier in policy right now from the European Central Bank?

DAVID: So I will admit I have not looked at the Eurozone nominal GDP trend path or the level of nominal GDP. But yeah, it would be a similar exercise. Again, I would look at forecast for nominal GDP. I can say though that I did look at this back in 2010, 2011, when the Eurozone crisis took off, and they fell well below the Euro, the nominal size of their economy. So it would help to get back.

And again, the big contrast, at least in the U.S., between the quick recovery in 2008 was, I think, fiscal policy played a big role. So I do think, to some extent, when you hit the zero lower bound, at least in the minds of Fed officials, their hands are tied to the extent of what they can do. They can do QE. They can do zero rates. Now, some would argue they could do more—negative rates, start buying up private assets. There are all kinds of interesting ideas out there, but I do think the big difference between 2008 and 2020 and '21 was fiscal policy. I want to be careful when I say we overshot and maybe there's too much stimulus because at the same time, that quick recovery is remarkable. We actually went back to trend. We just overshot it unfortunately, but the fact that we could close a gap that quickly says that we do have the tools available. It's just how do we use them more carefully next time? So we kind of thread the needle and get under the right trend path.

KATHY: Yeah, I think that that fiscal policy aspect of it has to be obviously taken into consideration because that does a huge contributor to our recovery. And I think the fact that the U.S. recovery has been so much stronger than what we've seen in the rest of the world. Well, we know that the Fed is working on its framework. Every once in a while, it updates its framework for policy. And that's kind of a fancy way to say they rethink everything that they're doing, right? They try and update it. Do you think any of these ideas will make it into the new framework? I think it comes out in 2025 if I'm not mistaken.

DAVID: Yeah, they'll start discussing later this year, and then '25, they'll give an update if any to what they have. So I would like to think that we're already part of the way there towards a nominal GDP target. So the flexible average inflation target that they introduced in 2020 has elements of what they call "makeup" policy. So they make up for past mistakes. So that's the other thing, you can have a target that's a growth-rate version of the target or a level version, and based on what I've been saying, I favor a level. I want to return to the level path. I don't want to just grow. I want to make up for past growth or shortages or excesses. So FAIT, it definitely made up for inflation undershoots. It doesn't do it from above. It's not symmetric. But that makeup element over long periods of time should give you something close to the nominal GDP level target, not quite.

But I would note Jim Bullard, when this was announced, he was actually pleased because he said, "This is pretty close to a nominal GDP level target." I think it has some ways to go. In fact, I wrote a paper with a colleague called "The Fate of FAIT: How to Salvage FAIT." 

KATHY: Just to be clear, FAIT is "flexible average inflation targeting." So just in case somebody missed that, but I like the play on words there. That makes it fun. 

DAVID: My worry is that because of what we went through, FAIT might be dinged, might see some tweaks that are unfortunate. But I do think Fed officials are, they're familiar with this idea, going to your real question here. Will they go all the way to a nominal GDP level target? Probably not. They might make incremental steps. I think, you know, if there's anything, any lesson to be drawn is this idea, maybe more symmetry in the target. The challenge with any kind of price stability target, and so FAIT would be like a weak version of a price-level target, because it corrects from below. If you had a true price-level target, you've got to actually come down if you have like negative supply-side shocks. And that's why I actually was only from below. And no one wants to have a recession just to deal with oil prices or, or some other adverse supply shock. Nominal GDP targeting, the beauty of it is you don't. Nominal GDP targeting, you only do level changes due to demand by definition.

So I think FAIT is a step in the right direction. I think there's still room to go. Will they get there? I'm not going to bank on it, but I am definitely advocating. We're doing a bunch of work at Mercatus just to make sure it's taken seriously as a part of the conversation. It got a little bit of airplay last time, but I don't think enough. And hopefully this time we'll get some more consideration.

KATHY: And I do think you touched on something interesting, because one of the questions I often get from, you know, our clients or people who are thinking through all this inflation stuff, and they go, "Well, how can, like right now, how can the Fed ease with oil prices going up?"

And I always come back to the idea, "Well, they can't target oil prices," right? They can't gear the entire economy around what OPEC is doing with oil prices. You can imagine how policy would go up and down and all around when oil prices move. So I like that that component actually gets just sort of pulled into the whole policy mix, and you're focusing on the demand side, not on what the price of some commodity, no matter how important to the economy, what the significance of that is, it can't drive policy. Otherwise, we'd be going nuts in terms of policy changes all the time. 

So we've been talking about the Fed and what they're kind of wrestling with now when setting their framework. The topic that keeps coming up is r-star, or the neutral rate of interest. So do you think that you can mesh together the nominal GDP targeting with this whole issue of r-star and have it work as a policy mix?

DAVID: Yes, I think you can. If you frame nominal GDP targeting in terms of like an interest-rate rule, so some of your listeners may be familiar with the Taylor rule, which says the way the Fed should adjust the interest rate is, you set it equal to some neutral or r-star measure, plus if there's slack or excess inflation in the economy, you adjust to that as well. Well, it would be very similar. You'd have your interest rate set according to some neutral rate, plus if there's excess or shortage in aggregate demand or nominal GDP. You would still need that r-star measure there to kind of be your benchmark for where your rate should be, but then you would adjust it based on whether you're overshooting or undershooting your nominal GDP target. So definitely would be part of the package if you went to nominal GDP. So in some ways, nominal GDP is not that radical of a departure. I just think it makes it easier for the Fed to do what it needs to do.

KATHY: Yeah, that makes sense. If we follow the literature, you know that the estimates of r-star have come down over the years, but there's a great deal of uncertainty of what that actually is, right? 

DAVID: Yeah.

KATHY: And what it will be, let alone today, what it will be in five years from now. So that introduces another element of complication if you're sitting at the Fed, is like, what is the neutral rate? It looks as if it's moved up a little bit. The estimates from the Fed seem to be moving up a little bit. One would think maybe it's moved up a bit, given how dynamic the economy has been. But I don't know if you have thoughts on r-star, if you've done any work on it, but I'd be curious as to what your take is.

DAVID: Well, I think it is useful to think of like a short-run version of r-star and a long-run version. And a short run can respond to any number of things. I definitely think that the short run at least has gone up and maybe the long run. But what you just mentioned, dynamic, the fact that the economy is still running relatively hot, are definitely full employment levels of the economy. You know, we just got the labor market report on unemployment—it's down 300,000 plus jobs. I mean, everything points to a very healthy running on all four, you know, cylinder types economy. So things look great. And if the economy is running this hot, and it seems sustainable at this point, you may need a higher interest rate just to keep it from overheating. And that's kind of what r-star is. It's based on the fundamentals. So the other thing I would note is productivity. Productivity growth appears to be going up.

I mean, you may know more about than I do, but it looks like it's going up. And if that were to be up permanently, then I think definitely r-star would go up also long run because productivity affects return on capital, the return on the economy, which in turn would affect interest rates. So it's possible that long run r-star has gone up, but I think definitely short term. I mean, another example of this would be like the fact that housing hasn't really buckled as much as we thought it would, like, and I'm a good example of this. I refinanced in '21, very low interest rate. And so I'm feeling no pain from the Fed's rate hikes right now. Now, if I wanted to move, I probably would. So you may need to keep them higher, at least temporarily, given folks like me who've locked in and kind of insulated ourselves from those rate hikes. But eventually it should have some effect, and it just may take longer, which means at least the short-run r-star needs to be up a little bit higher.

KATHY: I would agree. I would note that where we are seeing more impact is on things like credit cards and auto loans and delinquencies on those. So my brother's long history of working in car dealerships, and he follows some of the auction markets, and he said, you know, "We're getting all of these cars off lease that have very, very high lease payments that clearly people can't maintain," right? And so, and that's a direct result of those lease payments having jumped because of the higher interest rates. And now it's getting more difficult to get those deals. So I think it's there. It's just not there in a big way yet. But definitely feeling that under the surface, and same with the credit card situation.

But I want to stick with central banks because this is interesting topic. I hope our listeners are as interested as I am in it. So we've got the big three. We've got the European Central Bank, we've got the Fed, and we've got the Bank of Japan, seemingly all going in different directions, with Japan trying to raise rates, and they've exited the zero-interest rate policy. You've got the ECB kind of treading water here despite the drop in inflation and growth, but maybe they'll lead the way in this cycle. What's your take on how we ended up in this place where we all thought we'd have sort of a synchronized major central bank move here, and we're just splintering in different directions. I mean, you could start with Europe and tell me what you think ECB might need to do, and then we'll go to Japan, which is endlessly, endlessly interesting to talk about.

DAVID: Well, it's interesting you mentioned that because I have in the past written some papers on the Fed, and I'm not the only person, there's a large literature on this, the Fed typically tends to set the pace or rate hikes or rate cuts in the global economy. So even the eurozone, which is an independent, monetary authority, tends to follow the Fed. It can't really avoid what happens to the value of the euro and other things when the Fed does cut. So it's been, yeah, quite surprising, these different trajectories.

And if I had to put in one explanation, I think it might be just the fact that we had such a robust fiscal policy that we went back to in the U.S., might play a role. And maybe the different structures of the economy. I mean, Japan's aging, Europe's more fragmented, doesn't have unified fiscal policy. So I think three different regions, I'm sure there's more complications to it than that. I would say the one thing, though, that at least the ECB, the Fed, and a few other countries we haven't mentioned have in common though, in terms of monetary policy. And this is a little bit maybe off of what you're asking, is dealing with the large balance sheets that they've built up over the pandemic. And I'm someone, in addition to nominal GDP targeting, I really like central banks to have a small footprint in the economy. And I really would love to see us one day in the U.S. go back to what's called a scarce reserve or a corridor operating system. Basically, the Fed would have a much smaller balance sheet, and it would only have the reserves necessary that banks would need to settle balances, and also demand for reserves would be very different.

But we're not there. We're in an abundant reserve. The Federal Reserve has made it clear we're going to stick with this. A big balance sheet's going to go down some, but not … nowhere near what it was, say, pre-2008. The ECB, on the other hand, they just had a major review of how they do business, so the operating framework. So nominal GDP targeting, you think, is the target, and then there's how you actually implement it, the operating system. And the ECB has re-evaluated, and it announced in March it's going to change the system a little bit closer to something maybe we had pre-2008, but not all the way there. And what's interesting is a number of other countries, the Reserve Bank of Australia, Bank of England, and the Swedish National Bank also. They've looked at their large balance sheets and the cost that it's incurring for these balance sheets. A lot of them are losing money on it. And they've made a concerted effort to try to shrink and go back to a smaller balance sheet.

They also, many of them would like to see overnight interbank lending among banks, which does not happen if the market is flooded with lots of reserves, which like in the U.S. we have, there's no need to go to another bank and to borrow from them. But if you get rid of some of that, you can encourage interbank overnight unsecured lending. And that's a market that doesn't exist in the U.S. anymore in many places, but it's important. The more markets you have, the more price discovery you have.

And many of these countries are hoping to get back in that direction. So that's something I'm watching pretty closely to see how well this goes. I think for many of these central banks, they're not sure where this journey will go because I don't think we'll ever get fully back to where we were pre-2008. A lot of things have changed, but they're starting the journey. And I would really encourage the Fed to start a similar journey. We talked about the Fed review and its target. I wish they would review how they do things. 

KATHY: So we know the Fed would like a smaller balance sheet. I think most of the central banks would like a smaller balance sheet. But let's talk about Japan. If we're talking about big balance sheets, we have to talk about Japan. They not only have bought up almost all the government bonds, but ETFs tied to the stock market. I mean, they went all in after their property crisis that led to their banking crisis that led to 20 years of expansive central bank policies. And now they're trying to turn the corner, right? Trying to inch their way out of that. What do you think the lesson is there, and do you think they can succeed at this? Because it looks to me like a very long journey for them.

DAVID: Yeah, I would be surprised. I mean, just going on the history, they've struggled with deflation. I know they've gotten some inflation recently, but can it be sustained, given their demographic challenge? I'm not sure. I mean, they tend to be the avant-garde of every issue central banks face. They're the first ones to do QE in 2001, 2006. And they're, I believe they're first ones to do yield curve control. Now they've kind of signed off on that. So in some sense, this is a very melodramatic moment, kind of like the leader of central bank experimentation has signed off. "We're done." But like you said, it's too early probably to have complete judgment. The one, I think, interesting takeaway I would pull from this experience is tied to the ETFs you mentioned. So if I read correctly, they have like $475 billion in ETFs. So it's a decent amount of the Japanese stock market. And you know, my first reaction would be, "Oh my goodness, the government's getting its hand in corporations, stock market," but at the same time, if you look at the central bank's balance sheet, Japan actually had a bunch of unrealized gains on its balance sheet from all this equity it's holding. So where most central banks just hold bonds, and they've lost, bonds have gone down in value, interest rates have gone up. Bank of Japan is actually, their central bank balance sheet is not bleeding. It's a more diversified balance sheet.

And I actually got the chance to ask the previous governor of the Bank of Japan, I was at a conference, I ran into him, I said, "What do you think about ETFs?" Because it is controversial here. And he made this very point—it's a more diversified portfolio. So there is this academic debate. I don't think it's a very practical one for any central banker in the U.S. or Europe. Well, maybe so in Europe, but in the U.S. definitely not. And that is, should the Fed just buy government bonds, or should it buy a more diversified portfolio? What does it mean to have a small footprint?

You can imagine a small footprint being "replicate whatever the average investor holds," which may not be such a thing, but try to minimize the distortions you leave in the financial system. That may include buying some private securities, not just government ones. That's what Japan has done. Now, I don't know if they intentionally were thinking, "Hey, in the future, when rates go high and every other simple bank's losing, we're going to be winners." I doubt they had that in mind. To me, at least, the takeaway is a diversified balance sheet pays off not only for individual investors, but also for central banks.

KATHY: Well, that's a really interesting take. As you say, in the U.S., I think that's just a non-starter for most people. 

DAVID: Right.

KATHY: The idea that the central bank would get more aggressive in terms of its activity in the market would be anathema, I think, here in the U.S. You could see heads exploding among the talking heads, you know.

DAVID: Well, that's my first reaction too, because I don't want the Fed determining governance issues at some big corporation myself. So very politicized, there's a lot of questions that it raises. But if there's one interesting, I guess, unexpected outcome from Japan, that would be it.

KATHY: Yeah, no, it's interesting. I mean, the fact that the Fed is having trouble unloading its mortgage-backed securities would mean that they could be committed to this diversified portfolio that they have now for much longer than I think they ever anticipated would happen. So this has all been really interesting, and I find this a fascinating topic and have been doing a lot of reading on it lately, but if you're sitting at home, and you're a listener who likes to keep up on what's going on in the financial markets and among central banks and how the system all works, what would be kind of the one or two things you'd want people to take away from this conversation?

DAVID: Well, one, and this goes back to our first discussion, I think people should follow nominal GDP closer. I think that is a better, more consistent measure of the heat of the economy. Again, in plain English, it's total money spent. So it's money, how often it's being spent. That's an important metric I think is underappreciated. So I would spend time there looking at that. Now, of course, it comes out quarterly, so there are data issues. The other thing I would do is, you know, what I tend to do is look at market forecasts as well as just regular, you know, consensus forecasts. I think they're useful also. "Where is the Treasury bond market telling us inflation will be in the future?" Or "Where does the bond Treasury market think that r-star is going to be? We're going to look at five-year forward TIPS." And I think it's useful to do that because there's, you know, the wisdom of crowds, of these people have skin in the game. So it's useful, although to be clear, they made some mistakes in the pandemic, making predictions, along with everybody else.

But I would rely on asset prices to really inform my forward thinking and then also look at total dollar spending as a gauge, or at least a cross check on the normal measures that one would look at when thinking about the health of the macro economy.

KATHY: Yeah, I think a lot of people focus on money supply, but they don't focus on money spent. 

DAVID: Yes. 

KATHY: And I think that distinction is really important because we all know money supply growth has not, because of the velocity of money, has been down, not really done the job that it used to do. It doesn't have the same relationship to inflation that it used to have when I was younger, and that's all we focused on all the time, was the Thursday money supply numbers were huge events. But now I think it's a good distinction to talk about the money spent in the economy, not just the money quote-unquote "created." But I also think this is an intriguing idea. And I think it's good to point out that people are thinking about this stuff all the time. People at the Fed, at the other central banks, they're talking about it, they're doing work on it. It's not a static situation. There's a tendency, I think, to think, "OK, you know, the Fed's got its playbook, and that's that." There's constantly this exchange of ideas going on amongst economists, people like you, you know, and others in academia, etc. It's an ongoing process. That's one of the good things about having a rotation at the Fed is that you get new ideas. You get new people in. New research is being done at the regional banks.

And it's not a "set in stone" kind of thought process as much as I think it seems to be at times. But, yeah, I think this is going to be really interesting to see how all this plays out, particularly the balance sheet side of things as we get further away from the pandemic effects and start to see where the real economy can go or the nominal economy can go from here.

It's going to be fascinating to me to see how we keep up with that and how the policy changes play out. So I really appreciate your time today. I love this conversation, and we'll have to have you back again maybe after some framework information is out and we see what influence the idea of nominal GDP targeting is having on the Fed.

DAVID: Well, thank you for having me, Kathy.

LIZ ANN: Well, that is definitely a topical conversation these days, Kathy. Monetary policy, what the Fed's going to do, is obviously driving so many narratives right now. And speaking of narratives, what else is important in your mind to watch in the coming week?

KATHY: Well, as you mentioned earlier, we do have the PPI numbers and just a raft of economic data. We'll be able to parse through no end to Fed speak. The Fed speakers will be out in force giving us their interpretation of what's going on. So I think that's going to be the focus along with some of the other central bank meetings. We have the European Central Bank meeting. That's going to be interesting as we get closer to June where it looks like there may be a rate cut in Europe, and that would kind of lead off the cycle here for the major central banks. So that's what I'm focused on. What about you, Liz Ann?

LIZ ANN: Well, we get retail sales. Obviously, that's a proxy for the health of the consumer, and has had some volatility recently. A decent chunk of housing-related data, which these days is important just because of the moves in yields, you've got the NAHB Housing Market Index, which is basically a homebuilder sentiment index. So if yields continue on the upside, that could be interesting. You also get building permits and housing starts, those are components of the index of leading indicators. That also comes out next week. And industrial production, which is a factor that's in the coincident indicators and also one of the four key metrics that the NBER looks at when trying to define where we are in the cycle and recessions, etc. So that's what's on my radar.

KATHY: Thanks for listening. That's it for us this week, but you can always follow us on social media. I'm @KathyJones, that's Kathy with a K, on X, formerly known as Twitter, and on LinkedIn.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. Be sure to follow the real Kathy and Liz Ann because there have been imposter problems these days. But also follow us for free, very important in the context of the topic of this episode, with regard to CPI, for free in your favorite podcast app. And if you've enjoyed this episode, do us a favor, tell a friend about the show or leave us a rating or review on Apple Podcasts.

KATHY: Next week on the show, I'll be speaking with my colleague Collin Martin about credit spreads and private credit buyers in the corporate bond market.

LIZ ANN: And I'll have a conversation with another of our colleagues, Kevin Gordon, about our sector outlooks and the various sectors within the market and the economy. So stay with us.

KATHY: For important disclosures, see the show notes or schwab.com/OnInvesting.