Does a new GDP measure change optimal monetary policy?

At the 61st Annual Meeting of the National Association for Business Economics, The Fed’s chair Jerome Powell gave an insightful speech. The key takeaway from the speech was that in an evolving economy, monetary policy is very data driven.

Powell touched on three aspects of evolving economy: the consequences of an oil price spike, the measurement of output and productivity, and the role of tightness in the labour market.

In this post I will talk about the measurement of output and productivity aspect of the speech and some elements of that which will matter for monetary policy.

In my earlier post, I have described a new GDP-B metric introduced by Erik Brynjolfsson. Powell’s speech placed special emphasis on the role of that measure, and as a result I am going to talk about the monetary policy consequences stemming from this GDP adjustment.

In summary, there are three important consequences from any technological change:

• How technological change influences the use of factors of production.
• How technological change influences the response of firm investment to changes in expenditure.
• Howe technological change influences the response of consumers – and to the products provided – to changes in overall expenditure.

Given these changes, for monetary policy there are two channels that matter for this response:

• It’s influence on the neutral interest rate
• It’s influence on the responsiveness of output to changes in the interest rate

As a result, we’d like to think about how the technological change embedded in the GDP-B measure would change the first three issues, and thereby influence these two channels.

GDP-B and higher income growth

Brynjolfsson argues that if we incorporated the rise in consumer surplus obtained from free services provided by digital goods, we would end up in higher GDP growth numbers.

Now, how does this relate to the neutral interest rate?

It is easy to imagine that this would imply we need higher interest rates. Imagine a situation, where we had a sudden increase in GDP that we then view as providing a positive output gap. To respond to the shift in GDP, central bank would increase their interest rates.

But is this what is happening? No. GDP-B embeds “technological” change which changes the way factors of production turn into output. As a result, even if this does increase the GDP number it has also shifted “Aggregate Supply” to the right as well.

Our new measure of GDP does not tell us that it is additional “Aggregate Demand” or “Aggregate Supply” that is involved in the higher observed GDP number – all it tells us is that incomes are being undermeasured in a sense. It tells us nothing directly about the output gap.

Instead we need to rely on prices.

GDP-B and prices

GDP-B makes it clear that digital provision is leading to lower prices, or even free goods, which are increasing consumer surplus. Do these falling prices suggest lower interest rates?

At first glance no. A change in relative prices due to the provision of products in GDP-B does not indicate interest rates need to be lower – as a central bank will look through this price change (inflation expectations are expected to be unchanged).

But what happens if the rate of declining prices is expected to persist. Specifically, what happens if the importance of non-rival and free goods is expected to grow over time?

There are two things in this case:

• Lower average price growth in the future will be expected than in the absence of the change, implying that we need lower interest rates now to keep inflation expectations the same.
• If this is representative of a future where there are additional profitable investment opportunities from these future technologies (eg highly scalable business models) then this could increase current investment. This will drive up demand now, even though the factors of production now haven’t changed. This would suggest interest rates need to be higher now.

Ultimately, understanding which behaviour is most relevant will have a big impact on what we think is happening with the neutral interest rate. And our best indicator of all this isn’t a GDP-B measure – but appropriate measures of prices and inflation expectations.

Does looking at prices tell us everything we need to know about technological change and monetary policy? Not quite. Next week I will discuss how technological change may influence how responsive the economy is to monetary policy.