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

Thursday, March 29, 2018

Inflation and Unemployment (Part 2)

In my previous post (Inflation and Unemployment), I reviewed what I thought was a fair characterization of the way the Federal Reserve Board staff organize their thinking about inflation and unemployment, as well as how this view of the world was at least partly responsible for the "hawkish" overtone of current Fed policy. I also suggested that the inflation and unemployment dynamic might be better understood through the lens of an alternative theory that emphasized the supply and demand for money (broadly defined to include U.S. treasury debt).

I want to thank Paul Krugman for taking the time to critique my post and draw attention to an important issue that concerns U.S. monetary policy makers today (see: Immaculate Inflation Strikes Again). I was only a little disappointed to learn that I agreed with almost all of what he wrote in his column. But if this is the case, then what are we debating? And more importantly, how does it matter, if at all, for monetary policy?

The amount of disagreement in macroeconomics is often exaggerated and I think this has definitely been the case here. While we may disagree on some things, we seem to agree on the most important part, namely, on the present conduct of U.S. monetary policy.

Krugman begins his piece by stating three questions. Let me state the questions, followed by my own answers and comparisons.

1. Does the Fed know how low the unemployment rate can go? I have quipped before that this is one case in which the Fed can definitely count on a zero-lower-bound being in effect (and this is not just in theory, Switzerland had virtually zero unemployment throughout the 1960s, with low inflation I might add). But what this question is really asking is how low can the "natural" rate of unemployment go? I agree with Krugman: we don't know. But I'll further add: we don't even know if a "natural" rate of unemployment exists in the first place. It's just a theory, after all (which is not to say it shouldn't be taken seriously, only that we need to keep that important caveat in mind).

2. Should the Fed begin tightening now, even though inflation is still low? This is legitimately debatable--and the FOMC is presently debating it. My own view, on balance, seems presently more aligned with the "doves" on the committee. And so I also agree with Krugman on this score, namely, that the Fed could be tightening too aggressively. Krugman suggests that there are several reasons supporting his view and he mentions a few of them. They are all legitimate reasons, in my view. But I could add more reasons, based on my own preferred theory of inflation. The demand for money (broadly defined to include U.S. treasuries) appears to remain elevated. This disinflationary force has been in place for a long time and could, as I explain here, account for the lowflation phenomenon (see also here). If you follow that link, you'll note that I quote Krugman approvingly in regard to his view about monetary policy in a liquidity trap. Perhaps I am wrong, but I read Krugman here as not recommending that the Japanese lower their unemployment rate to raise inflation. Instead, he appeals to the model I alluded to in my post: a monetary-fiscal theory of inflation. If the Japanese want inflation, just cut taxes and finance social security spending by printing JGBs (as I recommended here). I'm not sure what this has to do with "immaculate" inflation. (I did learn from Nick Rowe that "maculate" is indeed a word.)

3. Is there any relationship between inflation and unemployment? I think it would be odd for any macroeconomist schooled in general equilibrium to suggest that the answer to this question is unequivocally no. The answer is yes. The real question is what type of relationship? In labor market search theories of unemployment, where firms and workers bargain over a joint surplus, a low unemployment rate can result in a higher real wage because workers have greater bargaining power. If a decrease in the unemployment rate leads to a rise in the real wage, it could, ceteris paribus, have an effect on the price-level (and, if prices are temporarily sticky, the adjustment could come along other margins). But an increase in the price-level is not the same thing as an increase in the inflation rate (though short-run price-adjustment costs can transform a price-level effect as a short-term rise in measured inflation). For workers to afford buying goods in the presence of ever-rising prices, their bank accounts are going to have to grow accordingly. Ultimately, this can only happen in aggregate if the aggregate quantity of money is growing, either through the banking sector or through the increase in the supply of outside money (including treasury debt). This is the sense in which I think inflation has to be a monetary phenomenon and that, moreover, the actual rate of inflation is ultimately not governed by whether unemployment is living above or below its "natural" rate, whatever that is.

So perhaps there's some room for debate on point 3. But we should be careful not portray the question as an "either/or" issue. We could just be two blind men, feeling different parts of the elephant--the two interpretations are not necessarily inconsistent with each other. We should try to work this out. On the plus side, it seems we are led to the same policy recommendation. This is something worth noting. (I plead guilty on the score of needlessly antagonizing people who "believe in" the Phillips curve. Rather than suggesting we abandon the theory, I could instead have suggested we supplement it with the monetary view.)

Does the debate over question 3 matter? Yes, it could, because different interpretations of how the world works usually--though not always---implies something different about optimal policy. The Phillips curve theory of inflation suffers from a free parameter problem: the natural rate is unobservable and hence, one can always appeal to a shift in the natural rate to explain away discrepancies with the data. However, the monetary theory I prefer also suffers from a free parameter problem: money demand is not directly observable either. I can always appeal to some unobserved shift in money demand to explain away discrepancies with the data. For this reason, it would be useful for economists to identify "robust" policies--policies that can be expected to deliver good results regardless of which theory best describes the world we are living in.

Is the Phillips curve view of inflation contributing to a policy mistake? I wanted to suggest in my post that it is, although this is not necessarily a fault of the theory as much as how it is applied. That is, there may be no policy mistake in the making if the FOMC simply lets its estimate of the natural rate fall freely as evidence of impending inflation fails to materialize. However, this is not what is happening. As Jim Bullard explained to me, he believes that Phillips curve proponents have a (strictly positive) lower bound on their estimate of the natural rate. The unemployment rate is so low now -- how can it possibly go any lower -- this has to lead to inflation in the near future -- it just has to. We'd better start raising now, before we find ourselves behind the curve.

Here is where the "monetarist" view could temper such resolve. Granted, the global outlook is looking relatively rosy, and fiscal policy seems expansionary--these are both inflation risks from a monetarist perspective. On the other hand, there is considerable uncertainty in this outlook, not the least of which is presently being fueled by talk of a global trade war. In uncertain times, consumers and investors are likely to lower their demand for goods and services--increasing their demand for safe assets, like U.S. dollars and U.S. treasuries. We can see these concerns weigh on long-bond yields. Market-based inflation expectations (like the 5yr-5yr forward) seem well-anchored. Current inflation is running below target. All of this suggests that the Fed can afford not to move aggressively at this time (to be fair, the FOMC regularly emphasizes the "data dependent" nature of its policy path). And yes, this is consistent with PC advocates that are willing to let their estimate of the NRU decline in line with the evidence.

This post is already getting too long and so I wouldn't blame you if you stopped reading here: the main points I wanted to make have been made. Still, I have a bit more to say, so in case you are interested...

Krugman presents the following data for Spain. He writes "Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment:"

Krugman asserts because Spain doesn't have its own monetary policy, that monetary factors were not responsible for swings in Spanish inflation and unemployment. But my interpretation of the great crash and subsequent rise in unemployment is that it was caused by a large positive money demand shock (where again, I stress, by money I include safe government debt). This positive money demand shock (flight to safety) is just the opposite side of what Krugman and others would label a negative aggregate demand shock. So once again, I think Krugman is digging moats (perhaps unintentionally) where he could be building bridges.

The other thing I should like to point out about the Spanish data is whether it suggests that low unemployment forecasts future inflation (which is really what my post was about). A naive reading of the data above suggests that low unemployment actually seems to forecast low inflation. Again, this suggests caution in using the unemployment rate to forecast inflation.

Finally, on Krugman's broader point: "economics is about what people do, and stories about macrobehavior should always include an explanation of the micromotives that make people change what they do. This isn’t the same thing as saying that we must have “microfoundations” in the sense that everyone is maximizing; often people don’t, and a lot of sensible economics involves just accepting some limits to maximization. But incentives and motives are still key."

I wholeheartedly agree.


  1. Loved these last two posts, David. I felt, though, that you walked right up to the edge of what would have truly aced your argument at the end and then left me sighing on the issue of relative demand for nominal wealth and its connection to inflation. There is one other factor involved in the hoarding or release of nominal wealth aggregates, and that is HOW nominal wealth is held (or accrued) in the first place. As you increase wealth/income inequality, nominal wealth aggregates are less likely to see disposal in a boom (or if it does, it is in Minsky's second price setting mechanism - that of real and financial assets, not goods and services). Thus, the mistake being made, even by those correctly focused on broad money, is in ignoring how nominal wealth is held and the fact that - of course - the rich are far less likely to release their excess nominal holdings into the consumption of goods and services.

    This, then, is the most profound difference between the impact of excess nominal wealth on inflation in this century versus the last. Those most likely to consume do not possess much in the way of excess assets (or any net worth at all, in many cases).

    Finally, low U3 needs to be expressed in the context of job quality, not just quantity. The quality of U.S. jobs has deteriorated markedly in favor of more low wage/low hours positions since 1990. This trend, which I am building into an index at Cornell, is an enormous offset to the positive effect of improvement in the headcount of those with a job. And, of course, is an additional expression of wealth and income polarization.

  2. Great pair of posts.

    Here is a question I would like see an experienced knowledgeable macroeconomics observer to answer:

    When and why did US macroeconomists become fixated (I won't say peevishly) on microscopic rates of inflation?

    If you say "Oh, after the 1970s-early 1980s inflation," I think you might be wrong.

    Consider this 1992 op-ed by Milton Friedman that ran in the Wall Street Journal:

    In the op-ed, when the CPI was at 3%, Friedman chastised the Fed for being too tight, despite the fact that the Fed had cut the funds rate in the previous three years to 3% from 10%.

    Through the Reagan years, the WSJ pushed the Fed to loosen up, as did the Reaganauts. Indeed, Reagan himself suggested placing the Fed into the Treasury (where it would answer the Oval Office, obviously). The White House loathed Volcker, and packed the FOMC against him.

    Today, no right-wing economist, and the bulk of macroeconomists, would dare utter such heresy as, "3% inflation is okay," or "The Fed is too tight."

    Indeed, the Fed recently adopted a 2% inflation goal, which evidently is actually an inviolate and perhaps radioactive ceiling (judging from Fed policies).

    So, decades after the inflation era, long after the PCE sank in low single digits---only then did academics, central bankers and related parties start fervently genuflecting to the sub-2% inflation totem, or even zero inflation (Charles Plosser has rhapsodized about deflation, usually with a seraphic expression on his face).

    Why this inflation-obsession now. as we recede further and further from the inflation days?

    BTW, fun fact: PCE core inflation barely breached 9%, fleetingly, in 1980 and quickly collapsed from there.

    The much-recalled "days of double-digit inflation"---well, see this chart.

    (adjust chart to annual percent change).

    The "days of inflation" were actually a few years of upper-single digit inflation from 1970 to 1980, falling inflation to 1987, and then sub-3% since 1992, or even lower.

    Is there an agenda behind the anti-inflation extremists?

    1. Well, I hope that others will chime in as well, but here's what I think.

      The current generation of monetary policy makers still have the 70s in their mind. You are right that official measures of inflation did not break double digits for long, but inflation was high. I have a vivid recollection, as a kid, buying potato chips at 5 cents a bag, then 10 cents, then 15 (with the bags getting smaller at the same time). But perhaps even more importantly, high inflations tend to be volatile inflations. In any case, rightly or wrongly, the general impression was that this high and volatile inflation was bad and the Volcker ended it at a terrible price. The Fed never wants to be placed in that position again. And I think that this, more than anything else, explains the extreme aversion to inflation. History shows that when the inflation anchor is let loose, it becomes hard to control.

      As for an agenda behind the anti-inflation extremists, who do you have in mind exactly? I'm pretty sure there's no political agenda on the FOMC. These people are committed to having the Fed fulfill its Congressional mandates, and that's it. Price stability (interpreted as 2% average long run inflation) is one of the Fed's important mandates.

    2. Well, I think your answer is right in some measure...but does not explain the increasing squeamishness about inflation that developed AFTER the 1990s, as the high single-digit inflation of late 1970s-early 1980s receded further into the past.

      As I said, in 1992, a Milton Friedman could accept 3% inflation...and that acceptance was only 12 years after the peak, 9% PCE inflation of 1980. The Reagnaut-WSJ crowd basically said 4% inflation was good enough, right after the worst inflation. They lived through your potato-chip days too. (Being the literate sort, I noticed comic books prices went up.)

      But who today can say, "Sure, 3% inflation. Piece of cake---worth it to get more output."?

      So a building inflation-phobia happened long AFTER the high single-digit inflation days….but what?

      Your memory of potato-chip bags suggests prices more than tripled in your youth. Maybe you had a long youth (you have company in that case).

      Unfortunately, the only FRED series I can find starts in 1985.

      It shows potato-chip prices not doing much until 2000, then curiously rising sharply though the Great Recession.

      BTW, slicing and then pan-frying potatoes in salt, pepper, butter and oil is cheaper and delivers even more satisfaction than potato chips. Even more calories. Not advised.

      As for agendas at the Fed or FOMC….well, that is long answer.

      There might be industry capture at a federal regulatory agency.

      You can fight deflation through money-financed tax cuts on FICA levies (yay!), or you could stuff commercial banks full of reserves, and then pay banks to do nothing with the reserves. No wry comments?

      There might be class-bias in a 4.75% natural rate of unemployment target (which works out to having about 1.3 people looking for work for every job opening). Oh, how nice.

      The Fed Beige Books are obsessed with worker shortages, but much,much less so with housing scarcity (induced by property zoning). Commercial banks lend heavily on property. Zoned property.

      There are 12 regional bank seats on the FOMC, but no labor seats, no manufacturing seats, no construction seats.

      Do bondholders want interest rates to go up?

      I wonder if the Fed is a lot like the USDA. It works closely with one industry….

    3. In terms of broad representation, you should remember that the 12 regional Feds have their own boards of directors drawn from a variety of local sectors. Moreover, many of the regional Feds have branch offices with their own boards of directors (the St. Louis Fed, for example, has branches in Louisville, Memphis and Little Rock).

      It's useful to be somewhat cynical; but not too cynical! Cheers.

    4. True about the regional bank presidents, although they turn out often to be the extremists, regarding inflation fighting.

      In general I do not think the system of regional bank presidents is a sterling example of transparency, accountability, and democracy in action.

      There is actually something to be said in favor of Ronald Reagan's idea of placing Federal Reserve policy within the Treasury Department. This would leave accountability for monetary policy in the president's office and citizens could vote accordingly.

      The opaque nature of the Federal Reserve results in all but a minute percent of the US public understanding monetary policy. If anyone does.

      The fact that monetary policy-making apparatus is so incomprehensible aids and abets industry-capture of the Federal Reserve, and provides a cocoon for the zany ministry's that survive for decades after empirical results vanish.

      See the Phillips Curve.

  3. Great post. I am not sure we will look at it and reply, but..

    As far as I know, some people argue that U.S has low inflation rate now because of AMAZON. They have been simplifying the products distribution of process, so we can cost less money to buy and sell. And that might be one of the reasons, of course fixed or lower real wage which is driven by deteriorated job quality could included.

    Now I wonder what you think about AMAZON as one of the reasons because you didn't mention it.

  4. Hi David,

    Great post.

    I think I know where this is going. There is a theory which does away with non-accelerating inflation completely and offers up trade-offs inherent to government subsidised ELR programs. What do you make of the talk surrounding these theories?


  5. Do you mind if I quote a couple of your posts as long as I provide credit and sources back to your blog?

    My blog is in the very same area of interest as
    yours and my users would certainly benefit from some of the information you
    provide here. Please let me know if this alright with you.