Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Monday, March 26, 2018

Inflation and unemployment

The FOMC decided on March 21 to increase the target band for the federal funds rate by 25 basis points, to a range of 1.50-1.75%. This despite inflation running persistently below the Fed's 2% target, only moderate wage growth, and inflation expectations firmly anchored.
What is the FOMC thinking here? To be more precise, what is the dominant view within the FOMC that is driving the present tightening cycle? Remember, the FOMC is made up of 12 regional bank presidents plus 7 board of governors (at full strength) possessing a variety of views which are somehow aggregated into a policy rate decision. I think it's fair to say that the dominant view, especially among Board members, is heavily influenced by the Board's staff economists. So, maybe what I'm really asking is: what is the Board staff thinking?

Perhaps they're thinking along the following lines. Thanks in part to a recent change in U.S. fiscal policy and in part to a relatively robust world economy, the U.S. economy seems poised for a growth spurt of unknown duration. As the economy expands, so too does the demand for investment and credit which, in turn, puts upward pressure on market interest rates. If the Fed does not follow this pressure upward (by raising its policy rate) then it risks inefficiently "subsidizing" investment spending and credit creation (leading to excess credit and spending). There might even be some justification for raising the policy rate more aggressively than what the market would dictate on its own, if it is judged that the imminent growth spurt was due to an "irrational" exuberance or if it is otherwise judged to be unsustainable (and subject to a sharp correction).

The view above may constitute an element of the way a few hawks on the committee are thinking when they cite financial stability concerns. But economists at the Board are probably not thinking exactly in this way because it offers no direct link to the Fed's dual mandate of promoting price stability and full employment. Price stability is interpreted by the FOMC as a long-run PCE inflation rate of 2% per annum. And while there's no official measure of "full employment," for all practical purposes it is defined as a situation in which the unemployment rate is at its "natural" rate.

What is the "natural" rate of unemployment? The Board defines the term here. According to this statement, it corresponds to the lowest sustainable level of unemployment in the U.S. economy. How do we know what this lowest sustainable level is? The statement implicitly answers this question by mapping "lowest sustainable level" into some notion of a "long-run normal level" of the unemployment rate. In short, take a look at the average unemployment rate over long stretches of time and assume that it roughly corresponds to what is sustainable. In his recent press conference, Fed Chair Jay Powell explicitly mentioned that any such estimate will a have large confidence interval--that is, we don't know what the natural rate is and we suspect it may change over time. (He might have mentioned that we're not even sure this theoretical object exists in reality but, of course, we could say this of any theoretical construct in economics, including supply and demand curves.)

In any case, here is a plot of the U.S. civilian unemployment rate since 1948, along with the Congressional Budget Office's estimate of the "natural" rate of unemployment:
The unemployment rate does appear to be a relatively stationary time-series. What's interesting about the U.S. data is that the unemployment rate only appears to rise in periods of economic recession (when GDP growth is negative). Moreover, there's evidence of a cyclical asymmetry: when it rises, it rises sharply, but when it declines, it does so relatively gradually (these patterns are not so evident in other countries).

The Board's concern, at present, is the fact that the unemployment rate fell to its (estimated) natural rate of 4.7% early in 2017 and has since declined steadily to 4.1% today. Given a relatively robust global economy, and given the recent fiscal stimulus in the U.S., the unemployment rate is projected to decline even further in the foreseeable future. This, evidently, is bad news. Why? Because it's unsustainable (read: likely to end badly). The economy is presently operating above its long-run potential level.

What does any of this have to do with inflation? Inflation is the rate of change of the price level (the "cost of living" measured in dollars). Sometimes people speak of wage inflation--the rate of change of the average nominal wage rate. Way back in the day, William Phillips noted an apparent inverse relationship between the rate of wage inflation and the unemployment rate. Others noticed a similar inverse relationship between the rate of price-level inflation and the unemployment rate. This statistical relationship became known as the Phillips curve.

The standard interpretation of the Phillips curve, a version of which is used by the Board staff today, goes something like this: To the extent that business cycles are caused by movements in aggregate demand (e.g., bouts of optimism or pessimism) then one would expect the general level of prices to rise when aggregate demand is high and to decline when aggregate demand is low. Moreover, one would expect firms to recruit workers more intensively when aggregate demand is high than when it is low, so that the unemployment rate should decline in a boom and rise in a recession.  In this way, aggregate demand shocks cause unemployment and the price-level to move in opposite directions. One would expect the inflation-unemployment relationship to reverse if a recession was instead triggered by a supply disruption (e.g., an oil price shock).

Importantly, the consensus view is that there's no long-run trade-off between inflation and unemployment (or, if there is, it seems to go in the opposite direction). Here's the relationship between inflation and unemployment in the U.S.
Apart from the oil supply shock episodes, inflation and unemployment do tend to move in opposite directions in recessions. But recessions are short-lived, and the relationship between these two variables during economic expansions is much less clear. For example, inflation and unemployment both fell from December 1982 to January 1987, from June 1992 to March 1995, and from August 2011 to October 2015.

It's hard to tell from this data alone whether low rates of unemployment portend higher inflation because in the background we have the Fed raising interest rates when there are signs of inflationary pressure. On the other hand, it's probably just as reasonable to expect the opposite. That is, in a deep demand-driven recession that drives the unemployment rate up and the inflation rate down, the high rate of unemployment at the trough should forecast higher future inflation (assuming that inflation is expected to return to target).

Is there any evidence that a low unemployment rate during an expansion forecasts higher future inflation? My feeling is that the empirical evidence is weak on this score. If so, then it is odd that so many people seem to believe that "low unemployment causes higher inflation." One can see this idea manifest itself in headlines like this: Fed's Mission Improbable: Lift Unemployment--But Avoid Recession (by Greg Ip of the WSJ). I reproduce a few of the opening paragraphs here for convenience:
Massive tax cuts, robust federal spending and a synchronized global upswing are expected to push annual growth in economic output to 2.7% this year and 2.5% next—past what Fed officials consider its long-run sustainable rate of 1.8%—according to projections Fed officials released after their meeting Wednesday
To sustain such growth, the Fed projects employers will have to dig deep into a diminishing supply of workers. That will cause unemployment, already at a 17-year low of 4.1%, to sink to 3.6% by the fourth quarter of 2019, a level last seen in the 1960s. That’s well below the “natural rate” of 4.5%, which is the rate Fed officials and many economists think the economy can sustain without eventually producing inflation. 
But it faces a problem: In theory, unemployment will eventually have to go back to 4.5%, or inflation will head even higher. Yet since records begin in 1948, unemployment has never risen by 0.9 points, except in a recession.
This almost makes it sound like the Fed is trying to increase the unemployment rate.  Of course, this is not how Fed officials would describe their intent. The goal is to ensure that the economy does not embark on an "unsustainable" (bound-to-end-badly) growth path. To hedge against this event, the Fed will have to raise its policy rate to keep aggregate demand and inflation in check. The collateral damage in this hedging strategy is for the unemployment rate to rise (hopefully in a smooth manner and to more sustainable levels).

I think it's time for economists to stop relying so heavily on the Phillips curve as their theory of inflation.There are two good reasons to do so. First, it's bad PR to (unintentionally) suggest that workers are somehow responsible for inflation. Second, and more importantly, it would help avoid policy mistakes like raising the federal funds rate too aggressively against low unemployment rate data.

To see the potential for policy mistakes, recall how in December of 2012 the FOMC adopted the so-called "Evans rule" (named after Chicago Fed president Charlie Evans):
In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
I pointed out  here at the time that while the Evans rule was meant to signal a more Dovish policy, it was inadvertently signalling a more Hawkish policy. As it so happened, the Fed did not raise its policy rate when the unemployment rate broke below 6.5% in April 2014. But it might have, and markets likely hedged against this possibility, resulting in a tighter than desired monetary policy.

In any case, back to the current tightening cycle and the factors influencing it. A few FOMC members are asking what the apparent rush to raise rates is all about. Jim Bullard, president of the St. Louis Fed has long been a vocal advocate for data-dependent policy. Inflation remains below target and long-term inflation expectations are on the low side as well. According to Bullard, the Fed can afford to be patient (and to move rapidly as conditions dictate).

One counterpoint to this view is the idea that the Fed needs to "get ahead of the curve." Again, the notion is that while inflation remains below target, we are confident that it will soon return to target and we can see inflationary pressures building up in the horizon (as evidenced by the very low rate of unemployment, among other things). I saw Charlie Evans push back against this idea pretty effectively on a recent CNBC interview. According to Evans, the "getting ahead of the curve" idea is largely a byproduct of an era where inflation was almost always above target. In the past six years, however, we've been operating in an environment where inflation has been persistently below target. Getting ahead of the curve is perhaps not as pressing an issue as it once was. A doubling of the inflation rate from 1.5% to 3% is not as disconcerting as a doubling from 4% to 8%.

I think that Minneapolis Fed president Neel Kashkari has a pragmatic approach to the problem (see the reasons he gives here for why he dissented for the 3rd time against raising the policy rate).  Suppose we subscribe to the notion that a below-natural-rate of unemployment portends future inflation. Suppose further we admit that we do not know where the natural rate of unemployment resides (as mentioned above, Fed Chair Jay Powell alluded to the uncertainty surrounding this estimate). Well, then why not just assume that the natural rate is declining as long as we see no evidence of price or wage inflation pressure?

If we abandon the traditional Phillips curve view of inflation, what do we replace it with? I think that the traditional money supply/demand approach provides a firmer foundation for understanding inflation (see here, here and here). In particular, we can expect the price-level to rise as households and firms attempt to dispose of excess nominal wealth balances (as when government debt is issued too rapidly when an economy is near full employment--a situation much like today). Conversely, we can expect the price-level to decline (or inflation to slow down) as the demand for safe nominal wealth rises (as in times of crisis). The framework is perfectly consistent with the Phillips curve, but with the direction of causality mainly reversed. That is, we can "blame" unexpected swings in inflation/deflation (emanating from deeper forces) for influencing the unemployment rate, and not the other way around.


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  2. The weak relationship between inflation and unemployment during an upturn could be down to inflation expectations taking time to get into gear. I.e. workers maybe reluctant to push for wage increases just at the moment because they've had their confidence knocked by the recent recession. Plus employers may be reluctant to raise prices for the same reason.

    But after a couple of years of low unemployment, workers and employers will perhaps get more cocky.

    The reverse certainly seems to apply: that is, once inflation expectations are in the system, it takes time to get rid of them, as Paul Volker discovered.

  3. I don't understand how your "traditional money supply/demand" framework avoids a Phillips curve with the more usual causality.

    Agents have excess money balances and try to spend them. This exerts upward pressure on prices in the goods market. But we won't get any upward pressure if the real marginal costs for goods production are completely constant. Indeed, in a world with even partly sticky prices, the extent of upward pressure depends completely on what happens to real marginal costs. By far the most important component of these costs, especially in the medium to long term, is labor. So the inflation mechanism, even if we interpret it as coming from money balances, ultimately hinges on how marginal labor costs change in response to rising goods demand. And presumably this has something to due with labor market tightness (how easily can firms elicit more effective labor from their current workers or new workers?).

    I'm not saying this will result in a Phillips curve with the exact traditional specification. There are a million things about labor markets and wage- and price-setting that we don't understand. But it is hard to avoid some kind of labor market tightness block as a crucial component of the transmission mechanism from money to inflation. I've never seen a convincing argument otherwise - usually it's just with toy models where one can slip over the labor market side.

    1. Imagine a world without money (perfect credit markets). And imagine that there are search frictions in the labor market. Bilateral meetings (workers and firms) with (real) wage negotiations that share the match surplus. The (Nash) bargaining power of workers will depend on labor market tightness (ratio of vacancies to unemployed). Shocks will cause the equilibrium unemployment rate to vary. Wages will vary as bargaining position changes and as productivity changes. This has nothing to do with inflation. Perhaps this is a place to start thinking about what the labor market has to do with the inflation process. My answer: nothing.

    2. Okay, now add even epsilon price rigidity to that world. Then you'll get something that looks like a Phillips curve for prices with firms' real marginal cost as an argument. And to first order, changes in that real marginal cost will depend on the gap between labor market tightness and some "natural" level of tightness that emerges from the real model that you have sketched. Putting these ingredients together, we will get something that looks like a Phillips curve - even if, admittedly, its exact structure depends on our assumptions about price rigidity, and the "natural" level may be so hard to pin down with data that it is a near-useless concept in applications.

      I think I see where you're coming from: you start from a baseline with no nominal rigidity at all, and in that baseline equilibrium prices will adjust in a way that doesn't seem to have much to do with the labor market. What I'm saying is that if we perturb that assumption just a bit - if we require that prices are set by individual agents in response to the prices and market conditions they face, and not always instantaneously - then the labor market comes into play, and in a decisive way. That's because costs are a crucial determinant of firms' desired prices (which tell us what direction they're going to try and move prices), and labor market conditions are a crucial determinant of costs.

      I think a baseline where firms have to adjust prices or wages in a deliberate and not-instantaneous way, rather than having them transmitted through an ethereal Walrasian auctioneer, is the most intelligible way to think about macro. And in that world, pretty much all the mechanisms that you're pillorying are there. I'm not saying we need to embrace whatever quirky New Keynesian cocktail is prevailing in the quantitative literature at this moment (indeed, I think the usual model fails completely in thinking about price and wage- setting) - in my experience, the lessons here are much broader than that.

    3. None of my conclusions hinge on some ethereal Walrasian auctioneer. In the search models I work with, prices are determined by bilateral bargaining protocols. The effect on prices is the same in these models and for the same reason.

      I'm fine with people who prefer to interpret the inflation dynamic through the lens of the PC. I am personally not persuaded by it and I believe there is value in seeking alternative interpretations.

    4. In the real model you sketch above, there is no money and thus (I assume) no nominal prices, so I guess any discussion of inflation is undetermined - only the real wages are determined by bilateral bargaining protocols.

      But it's a fair point - if we did introduce a nominal asset and determine prices by bilateral bargaining, your conclusion would probably hold there. So it's not so much about the Walrasian auctioneer per se. Instead, I think it's about *finding equilibrium*.

      To clarify: you have a world where labor markets are irrelevant for Nash equilibrium, but are very relevant for out-of-equilibrium reaction functions. If we are sure that agents will always play Nash equilibrium right away, then we can safely ignore labor markets when thinking about price level determination. But if we're not so sure, and we think that either they'll struggle in finding equilibrium, or if we redefine "equilibrium" such that agents have lags in their behavior and can't immediately switch to the statically optimal Nash, then labor markets start to matter a lot. (In Krugman's terms: you can only have "immaculate" inflation if it's possible to coordinate on an equilibrium with the right amount of inflation, right away. Otherwise they'll be flailing, trying to adjust their prices to the right levels in response to changes in costs and market conditions - and those changes in costs will be determined in large part by the labor market.)

      I think that's the general philosophical question here: how much emphasis should we put on Nash equilibria themselves vs. the entire reaction functions that explain how we might get there? Models with nominal rigidities do a form of the latter by building lags into behavior, so that people can't optimize. I'm not convinced by the exact way in which these models describe nominal rigidities, but I am completely on board with the idea of introducing lags and inertia and confusion and general imperfection into human behavior. That's how humans are!

      This is why I'm a little frustrated with your "alternative interpretations" bit. If my alaysis above is correct, then you're taking a very strong position about how we should use models without any lags or inertia in decisionmaking, where agents have a way to get to a new Nash equilibrium immediately - and I think you should be defending *that* explicitly, rather than framing it as some vaguer and more general question of scientific uncertainty. : )

      (This vaguer framing would be more appropriate if you had a different kind of objection, like "I see how a labor market block must show up in inflation determination, but our models are so mickey-mouse that a quantitative Phillips curve with a particular functional form and slope is useless." I might be on board with that!)

    5. No, I am not taking a strong position about how we should use models without any lags or inertia in decision-making. Where do you come up with such an impression?! I make no mention in my post about equilibrium or rational expectations. Indeed, I have blogged before how "monetarist" conclusions can follow assuming completely myopic individuals; e.g.,

    6. Okay, glad to know that we're fleshing out the exact disagreement - you think that your point will hold up in a model with lags or inertia in decision-making, and I don't.

      Here's why I think it isn't robust to lags or inertia or anything else that prevents firms from setting their frictionless Nash equilibrium price. First, in my experience the following heuristic holds up well: if you try to explain how the mechanisms of the model, especially relating to decision-making, in *words*, then those mechanisms will turn out to be analytically important when you put in frictions that impede reaching the equilibrium. And this is how I'd explain the causality from money to the price level in words: with higher real money balances, people spend more, businesses have higher demand at their posted prices, and they try some mix of filling this demand by paying for additional factors of production (mostly labor) and raising prices, with the exact mix determined by how expensive those factors are at the margin (if factors become more expensive, then they raise prices more). This process continues, and firms keep raising prices, until real money balances reach a steady-state equilibrium level.

      With perfectly flexible prices, this story all plays out instantly, and the price adjustment that happens in equilibrium seemingly has nothing to do with labor markets - it's just enough to offset the effect of rising nominal money. But if it doesn't play out instantly, and there are lags in price adjustment, then the "factors becoming more expensive" part of the story (in explaining why firms raise prices) is crucial after all.

      This falls out immediately of the basic New Keynesian model. The path from Calvo prices and rational expectations to a NKPC with *marginal cost* in it is very short and straightforward, and doesn't require any other assumptions on the environment. If you swap out Calvo prices and RE for some other lagged pricing and expectations rules, you'll also get some kind of Phillips curve with marginal cost, just maybe with a different structure (backward-looking rather than forward-looking, etc.). The far more tenuous part is the link between marginal cost and labor markets, and that's where I think the unemployment Phillips curve is sketchy in practice - but certainly there is *some* link, whose sign is clear, between marginal cost and the tightness of labor markets.

      This is why I'm a bit befuddled by the claim that with even with lags and inertia in firm decision-making (including their rules for setting nominal prices), we can avoid a major role for labor markets in inflation determination. In literally every model I've seen or written with lags and inertia and a nontrivial labor market, that market is important due to the logic outlined above (tightness -> marginal cost -> inflation). If you have a counterexample, I'd love to see it, but I'd be *very* surprised.

      Indeed, the Luttmer model you mention in that link is the exception that proves the rule: it seems to assume *exogenous* output, so of course there isn't any role for labor markets. The same is true if we have exogenous labor, because then the marginal cost of labor discontinuously jumps from 0 to infinity, and in equilibrium assumes whatever value is necessary to make the rest of the model work. For labor markets to matter in the sense that there is a non-constant tightness measure that enters into marginal cost, you obviously need a less degenerate model than this.

      This is what I meant earlier when I criticized reasoning from "toy" models: yes, you can tell a story where labor market tightness doesn't matter by assuming exogenous output, but that doesn't tell us anything about what happens in a model with more realistic pricing and production.

    7. This is why I'm a bit befuddled by the claim that with even with lags and inertia in firm decision-making (including their rules for setting nominal prices), we can avoid a major role for labor markets in inflation determination.

      Go back and read my post carefully. I noted the PC relation seems to hold (for demand shocks) in a recession. In a GE model, it would be surprising if unemployment or any other variable did not play into the short-run transition dynamic.

      But then I went on to remark that the PC relationship seems much more tenuous outside of recessionary episodes. And, indeed, we've been almost a decade out of the last recession. Why are we thinking that low unemployment might be *the* cause of *future* inflation? Even Krugman's diagrams on Spain don't bear this out (they show a strong contemporaneous correlation).

      I seem to recall the PK himself had a nice paper on how Japan could raise its inflation trap in a liquidity trap. Believe me, the mechanism he proposed then had nothing to do with the PC and everything to do with monetary policy.

      As for your challenge to come up with a model, I will try. But please don't think for a moment that you have some sort of "realistic" model of how firms and workers make decisions. To begin, every model in the NK tradition relies on anonymous spot markets and linear pricing rules (and firms can only adjust margins along prices, not quality, reliability, credit, timeliness of delivery, etc.). I have an old post discussing this issue, if you're interested:

      By the way, thank you for the discussion -- it has been very helpful!

  4. I see that Krugman has linked to this post as an example of "immaculate inflation". I frequently disagree with Krugman, but I do agree with him on this point, and it's a useful way of summarizing my arguments above.

    I also think it's a more general point - a close analogue is discussion about the effects of monetary policy that ignores the role of the short-term nominal interest rate. A lot of monetarist-ish bloggers like to criticize mainstream macro's focus on monetary policy via interest rates, arguing that interest rates are really just an epiphenomenon, a distraction from the main mechanism. But if you try to identify the mechanisms, the actual decisionmaking at the micro level, you realize that interest rates are absolutely crucial, and if anything *money* is the distraction.

    The Fed has traditionally implemented monetary policy by intervening in an obscure market that virtually no households or firms participate in; this only influences real behavior because it affects much more important interest rates via expectations and arbitrage, and these interest rates matter for decisions. Meanwhile, the frictions associated with base money are trivial for most decisionmaking because it is almost costless to convert between base money and other assets (whether we're using an ATM for paper currency or Fedwire with electronic reserves). Even if we cared about these frictions, the only way that the Fed's policy can affect a household's portfolio allocation to paper currency is indirectly, through interest rates (since again, the Fed does not engage directly with households); maybe you'll withdraw fewer dollars from the ATM if the opportunity cost of foregoing interest is a bit higher.

    You can't escape the central role of interest rates as a summary of what matters for household decisions; toy models can obfuscate it, but it's no accident that rates are central to most larger-scale models.

    1. If what you say is true, then the government has the biggest free lunch ever: just cut taxes to zero and print money to finance all program spending -- after all, no household is ever going to notice the base money supply increasing.

      I'd very much like your feedback on this paper (just replace capital investment in the paper with recruiting effort or employment to convert to a labor market model).

    2. Many MMT'ers see it this way but it is not a sustainable monetary path. There is a reason governments tax before they spend and control the money supply through treasury bonds.

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  6. Excellent blogging. Quibble: membership on the FOMC rotates among regional bank presidents. I think it is four at any time plus the New York president but it might be five and the New York president.

    1. You are right. However, all of the presidents engage in the economic and policy go-arounds and the Chair takes into account all views expressed. Thank you!

  7. Never draw conclusions from a one-day wobble, and never reason solely from a price change.

    Still, 10-year Treasury yields fell today back to 2.79% from 2.85% last week. Uncle Sam plans to borrow nearly $300 billion this week.

    Being a conventional macroeconomist is very trying in these times.

    1. So, you observe the price of oil drop in a week where additional supplies are coming to market. You conclude: (a) conventional economic theory is wrong; or (b) the demand for oil must have risen more than supply.

      Until I have a better alternative, I'm picking (b).

      In the present context, standard macro theory says that a more pessimistic outlook should increase the demand for bonds. That the bond supply is increasing supply simply mitigates what would otherwise have been a larger increase in the price of bonds.

      Consulting fee: $0 :)

    2. Um. I think you may have to lower your fees:

      "So, you observe the price of oil drop in a week where additional supplies are coming to market. You conclude: (a) conventional economic theory is wrong; or (b) the demand for oil must have risen more than supply.

      Until I have a better alternative, I'm picking (b)."--DA.

      Your example is enough to induce dyslexia. Who's on first?

      No worries, I feel the same way when conventional economists genuflect to the Phillips Curve. I look on a chart and I see the Phillips Phlat-Line."

      For decades.

    3. Ha ha, Ben! I'm sorry. I meant to write "So you observe the price of oil *rise* in a week where..."

      Thanks for point that out!

  8. While I do not have a lot of use for the Phillips Curve, there is a simple explanation for the current data which needs to be considered:

    The actual unemployment level is substantially higher than the official numbers, because there are political pressures on the relevant agencies to report a low number.
    If this is correct, it explains a lot of things. It also raises a lot of interesting questions. . .