In a previous post, I wrote about a natural rate of inflation. Does it really exist? What would it look like?
We could understand a natural rate of inflation as the inflation rate at which the economy can most efficiently progress in terms of social benefits and costs. Some benefits are more employment, greater growth of GDP and lessening the burden of debt. Some costs are wealth reduction, business uncertainty and more price distortions.
How could we determine a natural rate of unemployment?
One way is to plot inflation (CPI, less food and energy) against unemployment. The cycle between these two variables is that as GDP is growing, inflation stays steady and unemployment is coming down. When GDP hits its natural rate at the LRAS curve, unemployment stops declining and inflation starts rising. The plot moves generally in a clockwise manner. However, since 1989, when unemployment stops declining and inflation doesn’t rise much at all. So in the following graph, we identify the points where unemployment stops.
The graph is a scatter plot of unemployment and inflation (quarterly) from 1967 to 2013. The red dots mark the points where unemployment was when GDP hit its natural level. (See the arrows showing direction of movement in 1978.) Thus, the red dots mark the natural rate of unemployment. I included 2 points earlier than 1967. Roughly speaking the black line connects the red dots to show if there is a connection between the natural rate of unemployment and an inflation rate.
The 7 points that we have before 2013 stay fairly close to the black line. What do we see? When inflation is lower than 3%, the natural rate of unemployment stays below 5%. If inflation goes over 3%, the natural rate of unemployment stays above 5%.
Thus we might hypothesize a couple of alternatives…
- that as inflation rises over 3%, the natural rate of unemployment tends to rise too.
- that 2% is the natural rate since most red dots occur there.
- that any relationship here is simply coincidental.
I assumed in the previous post that as inflation dropped below a certain level that the natural rate of unemployment would rise. The graph is showing the opposite of what I assumed and what I understood from a quote by Joseph Stiglitz.
So now look at the red dot labeled “Currently projected”. This is where I project the next red dot. Real GDP will meet its natural level at an unemployment rate of 7%. Most economists assume that unemployment will simply head back to where the rest of the red dots are. The difference is that I see the effective demand limit constraining unemployment at 7%, which never happened to the other red dots. The other red dots were always close to the effective demand limit.
Can one conclude from the graph that there is evidence for a natural rate of inflation? Maybe. I will say that the economy seems to gravitate to an inflation rate around 2%. I do not think that Fed monetary policy is totally responsible for that. And having more inflation does not seem to ultimately create more employment. I am left with a sense that a range from 2% to 3% inflation is sufficient for the economy. Above 3% and below 2% does not seem ideal or necessary.
One benefit from having higher inflation now would be that the debt burden would lighten for many who are deleveraging. But inflation is not going to rise to create this benefit. Inflation gets into a rut as it approaches the natural level of real GDP.
To wrap it up… we need some inflation as a shock absorber for adjustments. We need some inflation to complement the momentum of output growth. And I can see why the Fed decides to kill the inflation that can develop at the natural level of GDP. It can be disruptive.
Inflation is not the problem. The real problem with sluggish output growth and high unemployment remains weak liquidity among consumers. And the Fed may think that higher wages will cause inflation, but the evidence shows that higher wages would lead to output growth instead. (source paper for wage-led growth, thanks to Marko in the comments section.)