Ramesh Ponnuru and I have a new article at the New Republic where we argue the Fed should not consider tapering unless it is tied to a NGDP level target. If the target were based on pre-crisis trends over the "Great Moderation" period, then the dollar size of the economy is about 10% too small. If it is based on the CBO's full-employment level of NGDP then it is about 6% short. Either way, there is still a large aggregate nominal expenditure shortfall. The FOMC should make tapering conditional on closing this gap.
The FOMC and Bernanke, however, signaled a different type of tapering last week that sent the markets into a tailspin.Yes, Bernanke said the tapering would be based on the pace of recovery, but he also mentioned a timetable which raised questions about whether monetary policy will truly be state contingent. There may have more than this tapering confusion that rattled markets--such as China's tightening of policy--but the Fed clearly failed to signal a future path of monetary policy consistent with supporting the ongoing recovery. This is more passive tightening of monetary policy.
The Fed should realize it is not doing it right when The Telegraph's Ambrose Evans-Pritchard, President James Bullard, and IMF Managing Director Christine Largarde all agree the FOMC botched it last week. The Fed can make this right by talking up the right type of tapering. The kind that is conditional on closing the NGDP gap.