With unemployment at the lowest levels since the start of the millennium (initial unemployment claims in February were the lowest since 1973!), lots of people are starting to wonder if we might be headed for a pick-up in the rate of inflation, which has been averaging well under 2% a year since the financial crisis of September 2008 ushered in the Little Depression of 2008-09 and beyond. The Fed has already signaled its intention to continue raising interest rates even though inflation remains well anchored at rates below the Fed’s 2% target. And among Fed watchers and Fed cognoscenti, the only question being asked is not whether the Fed will raise its Fed Funds rate target, but how frequent those (presumably) quarter-point increments will be.
The prevailing view seems to be that the thought process of the Federal Open Market Committee (FOMC) in raising interest rates — even before there is any real evidence of an increase in an inflation rate that is still below the Fed’s 2% target — is that a preemptive strike is required to prevent inflation from accelerating and rising above what has become an inflation ceiling — not an inflation target — of 2%.
Why does the Fed believe that inflation is going to rise? That’s what the econoblogosphere has, of late, been trying to figure out. And the consensus seems to be that the FOMC is basing its assessment that the risk that inflation will break the 2% ceiling that it has implicitly adopted has become unacceptably high. That risk assessment is based on some sort of analysis in which it is inferred from the Phillips Curve that, with unemployment nearing historically low levels, rising inflation has become dangerously likely. And so the next question is: why is the FOMC fretting about the Phillips Curve?
In a blog post earlier this week, David Andolfatto of the St. Louis Federal Reserve Bank, tried to spell out in some detail the kind of reasoning that lay behind the FOMC decision to actively tighten the stance of monetary policy to avoid any increase in inflation. At the same time, Andolfatto expressed his own view, that the rate of inflation is not determined by the rate of unemployment, but by the stance of monetary policy.
Andolfatto’s avowal of monetarist faith in the purely monetary forces that govern the rate of inflation elicited a rejoinder from Paul Krugman expressing considerable annoyance at Andolfatto’s monetarism.
Here are three questions about inflation, unemployment, and Fed policy. Some people may imagine that they’re the same question, but they definitely aren’t:
- Does the Fed know how low the unemployment rate can go?
- Should the Fed be tightening now, even though inflation is still low?
- Is there any relationship between unemployment and inflation?
It seems obvious to me that the answer to (1) is no. We’re currently well above historical estimates of full employment, and inflation remains subdued. Could unemployment fall to 3.5% without accelerating inflation? Honestly, we don’t know.
Agreed.
I would also argue that the Fed is making a mistake by tightening now, for several reasons. One is that we really don’t know how low U can go, and won’t find out if we don’t give it a chance. Another is that the costs of getting it wrong are asymmetric: waiting too long to tighten might be awkward, but tightening too soon increases the risks of falling back into a liquidity trap. Finally, there are very good reasons to believe that the Fed’s 2 percent inflation target is too low; certainly the belief that it was high enough to make the zero lower bound irrelevant has been massively falsified by experience.
Agreed, but the better approach would be to target the price level, or even better nominal GDP, so that short-term undershooting of the inflation target would provide increased leeway to allow inflation to overshoot the inflation target without undermining the credibility of the commitment to price stability.
But should we drop the whole notion that unemployment has anything to do with inflation? Via FTAlphaville, I see that David Andolfatto is at it again, asserting that there’s something weird about asserting an unemployment-inflation link, and that inflation is driven by an imbalance between money supply and money demand.
But one can fully accept that inflation is driven by an excess supply of money without denying that there is a link between inflation and unemployment. In the normal course of events an excess supply of money may lead to increased spending as people attempt to exchange their excess cash balances for real goods and services. The increased spending can induce additional output and additional employment along with rising prices. The reverse happens when there is an excess demand for cash balances and people attempt to build up their cash holdings by cutting back their spending, reducing output. So the inflation unemployment relationship results from the effects induced by a particular causal circumstance. Nor does that mean that an imbalance in the supply of money is the only cause of inflation or price level changes.
Inflation can also result from nothing more than the anticipation of inflation. Expected inflation can also affect output and employment, so inflation and unemployment are related not only by both being affected by excess supply of (demand for) money, but by both being affect by expected inflation.
Even if you think that inflation is fundamentally a monetary phenomenon (which you shouldn’t, as I’ll explain in a minute), wage- and price-setters don’t care about money demand; they care about their own ability or lack thereof to charge more, which has to – has to – involve the amount of slack in the economy. As Karl Smith pointed out a decade ago, the doctrine of immaculate inflation, in which money translates directly into inflation – a doctrine that was invoked to predict inflationary consequences from Fed easing despite a depressed economy – makes no sense.
There’s no reason for anyone to care about overall money demand in this scenario. Price setters respond to the perceived change in the rate of spending induced by an excess supply of money. (I note parenthetically, that I am referring now to an excess supply of base money, not to an excess supply of bank-created money, which, unlike base money, is not a hot potato that cannot be withdrawn from circulation in response to market incentives.) Now some price setters may actually use macroeconomic information to forecast price movements, but recognizing that channel would take us into the realm of an expectations-theory of inflation, not the strict monetary theory of inflation that Krugman is criticizing.
And the claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious.
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:
That period of low unemployment, by Spanish standards, was the result of huge inflows of capital, fueling a real estate bubble. Then came the sudden stop after the Greek crisis, which sent unemployment soaring.
Meanwhile, the pre-crisis era was marked by relatively high inflation, well above the euro-area average; the post-crisis era by near-zero inflation, below the rest of the euro area, allowing Spain to achieve (at immense cost) an “internal devaluation” that has driven an export-led recovery.
So, do you really want to claim that the swings in inflation had nothing to do with the swings in unemployment? Really, really?
No one claims – at least no one who believes in a monetary theory of inflation — should claim that swings in inflation and unemployment are unrelated, but to acknowledge the relationship between inflation and unemployment does not entail acceptance of the proposition that unemployment is a causal determinant of inflation.
But if you concede that unemployment had a lot to do with Spanish inflation and disinflation, you’ve already conceded the basic logic of the Phillips curve. You may say, with considerable justification, that U.S. data are too noisy to have any confidence in particular estimates of that curve. But denying that it makes sense to talk about unemployment driving inflation is foolish.
No it’s not foolish, because the relationship between inflation and unemployment is not a causal relationship; it’s a coincidental relationship. The level of employment depends on many things and some of the things that employment depends on also affect inflation. That doesn’t mean that employment causally affects inflation.
When I read Krugman’s post and the Andalfatto post that provoked Krugman, it occurred to me that the way to summarize all of this is to say that unemployment and inflation are determined by a variety of deep structural (causal) relationships. The Phillips Curve, although it was once fashionable to refer to it as the missing equation in the Keynesian model, is not a structural relationship; it is a reduced form. The negative relationship between unemployment and inflation that is found by empirical studies does not tell us that high unemployment reduces inflation, any more than a positive empirical relationship between the price of a commodity and the quantity sold would tell you that the demand curve for that product is positively sloped.
It may be interesting to know that there is a negative empirical relationship between inflation and unemployment, but we can’t rely on that relationship in making macroeconomic policy. I am not a big admirer of the Lucas Critique for reasons that I have discussed in other posts (e.g., here and here). But, the Lucas Critique, a rather trivial result that was widely understood even before Lucas took ownership of the idea, does at least warn us not to confuse a reduced form with a causal relationship.
Uneasy Money 