Does targeting low inflation lead to higher unemployment?
In other words, is it possible that a higher natural rate of unemployment is necessary to maintain a lower rate of inflation?
Output and prices move together to maintain economic momentum. Normally output increases in response to demands in the market, which keeps prices stable. Yet, at those times when output cannot respond to the momentum of the market, prices will rise giving space for output to catch up. A higher natural inflation corresponds to when consumers have strong liquidity. A lower natural inflation corresponds to when consumers have less liquidity and are less able to drive the momentum of the market. When consumers have low liquidity, output finds it easier to respond to demands in the market, so price increases are less needed.
The basic idea is that if prices are constrained from rising when there are inflation pressures from commodities or consumer demand, jobs will be cut short. Firms will not be able to maintain as much labor. The increased pressures from costs not being released through higher prices will cut into production possibilities. Thus, higher unemployment corresponds with a lower inflation target.
Joseph Stiglitz wrote back in 2008…
“Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.” (source)
Does inflation have a natural rate? This seems to be the key question. Unemployment has a natural rate. Even GDP has a natural rate. If you push unemployment below its natural rate, you get problems of economic over-heating. If you push GDP above its natural rate, there are risks of inflation and economic over-heating too. What would it mean if the natural rate of inflation for the US was 3%, and the Fed kept trying to push it to 2%?
Here is an analogy. The natural rate of inflation is like a shock absorber on a car. You have bumpy roads where you live. So you have shock absorbers on your car that have a greater range of movement for the bumpy roads. When you keep your car speed commensurate with the conditions of the road, you have a comfortable ride.
Then the roads all start getting paved and made smoother. Over time the shock absorbers stiffen, which creates a more stable ride on smoother roads. You can actually drive faster now too. But if you then try to drive your car on the old bumpy roads, you will have to drive much slower or get tossed around.
A 2% inflation target is like paving the roads and streamlining transportation so that it can move faster with a more stable and smoother ride. But if the road ever gets bumpy, the tight range of the shock absorbers make you slow down much more on bumpy roads. A tighter inflation range restricts leeway in economic adjustments. The result from an economy going slower during rough times would imply higher unemployment. A higher inflation range would allow the economy to move faster on bumpy roads. An economy moving faster means lower unemployment.
The relationship between inflation and unemployment is also found in the Phillips curve, where you have inflation on the y-axis and unemployment on the x-axis. The curve can be vertical or downward-sloping. If the curve is downward-sloping, like the right side of a capital A, then higher inflation would bring the unemployment rate down. But it is a tricky game with monetary policy. If the Federal Reserve sets an inflation target of 2%, and people really expect 2% inflation (Fed policy has credibility) and the inflation rate averages 2%, then people get used to the rhythm of the economy and the inflation target matches the speed.
However, if the Federal Reserve was to set a higher inflation target and not tell anyone, people would feel comfortable even as the economy is moving faster. If the car is riding smooth, could the Fed slowly speed up the car without anyone really noticing and getting nervous? Could the Federal Reserve take advantage of stable inflation expectations?
“Should the central bank try to exploit the downward-sloping long-run Phillips curve and
secretly, by being more expansionary, try to keep average inflation somewhat above the target, so as to induce lower average unemployment than for average inflation on target? Such a policy would involve the central bank saying one thing (the target is 2 percent) and deliberately doing another (keeping average inflation above 2 percent). This would be inconsistent with an open and transparent monetary policy. Regardless of the moral quality of the policy, the truth might eventually be leaked or discovered, in which case the inflation target would lose credibility and inflation expectations would rise above the target, in which case the possible benefit of inflation above target would vanish.” (
source)
If the Fed tried to temporarily set a higher inflation target when the economy was moving smoothly, as soon as the economy hit some rough roads, the Fed would have to tighten more than if they hadn’t secretly been so loose and free. Some say this is what happened before the crisis.
So back to the original question…
Is it possible that a higher natural rate of unemployment is necessary to maintain a lower natural rate of inflation? Yes it is possible. A higher rate of unemployment puts less pressure on inflation, thus making it easier to keep inflation low.
Another way to look at this is… The Fed has been in a long-term plan to beat inflation down to 2%. By pushing the inflation rate lower for so many years, the economy has now shifted its institutions and dynamics into an equilibrium state of low inflation, which required a rise in the natural rate of unemployment to minimize inflation pressures.
The flip-side of this issue, is that… If the Fed was to now target lower unemployment, they would have to accept higher inflation pressures. Yet, the economy is structured around very low inflation. and We all know the Fed has decided in favor of keeping inflation under control. The trade-off is higher unemployment, subdued wage growth and low demand pressures.
So, to wrap up… the Fed has its 2% inflation stability, which is now projected to last for years. But the economy is needing more adjustment room from prices (inflation) in order to generate more economic momentum for output. More economic momentum for output would translate into more employment. The economy is needing a higher inflation target, but the Fed does not want to raise the inflation target, and even if they wanted a higher inflation target, they couldn’t achieve it, either secretly or openly. The economy is now stabilized at an equilibrium with lower inflation and higher unemployment.
Depends how much labor is part of prices.
If the economy is dominated by “knowledge” and “service” work, then low inflation and high “workforce availability” (control over labor prices) have to go together.
If the economy is dominated by physical product where labor is a small part of cost of sales and therefore prices, you should be able to have a lower rate of inflation and still have lower (than above scenario) unemployment.
There has to be a multiplier effect.
The “natural rate” of inflation to maintain certain employment levels should be higher in non-manufacturing economies, and in manufacturing economies, should be higher than economies dominated by extraction of raw materials (oil).
But DOES unemployment have a natural rate?
Just because standard economic theory builds in the concept of NAIRU doesn’t automatically validate it, and even less when people like you (Ed) are challenging conventional paradigms on every other front.
What we do know is that by and large the Fed has adopted a measure for NAIRU formally or informally and pegged monetary policy around economic reports about wages or employment that suggested we would be breaching that horrible “Non-Accelerating” rate. And even if you granted the principle has tended to operate with an abundance of caution approach that treated every bit of good news for labor (any combination of real wage increase and employment) as potentially bad news for bond holders and so an excuse to screw down the lid on the money machine. Until of course the risk of workers actually having more jobs at better wages subsided.
Ed to the extent I even grasp the details of your argument (because a lot of it is over my head) you see much of the problem with the economy today due to a restriction in demand for goods itself driven by a restriction in supply of wages to purchase those goods. Which suggests policies with boost both real wages and employment and so run head on into NAIRU and its implied “natural rate” of unemployment. It just seems to me that you are binding your own argument by blithly assenting to :
“Does inflation have a natural rate? This seems to be the key question. Unemployment has a natural rate. Even GDP has a natural rate. If you push unemployment below its natural rate, you get problems of economic over-heating.”
Perhaps unemployement does have a natural rate. On the other hand the forces of capital have been explicitly using that as a concept to beat down any gains that labor makes on either wages or employment since forever. And at the time it was obvious that it was impossible to combine Clinton era real wage, employment and inflation numbers at one and the same time. Until we did and in so doing called the whole concept of NAIRU into question, or at least the actual number for that ‘natural rate’. Suddenly 5.5% unemployment stopped being a Law brought down by Moses Friedman from Mount Chicago-Sinai. That is even if there was a NAIRU maybe it should be put at 4.5% or wherever.
I am willing to be convinced that one there is a NAIRU or a ‘natural rate’ of unemployment and that it sits at a particular level. But sitting as I do as a member of the working class from a working class family and knowing the history of NAIRU as an instrument of class warfare by capital against labor I am little inclined to just take any of that on a “of course” basis. And it surprises me a little that someone so willing to challenge conventional economic wisdom on other fronts just accepts that particular restraint as a part of his modeling.
A correlation between Inflation and unemployment rate could be testable at least, allowing for labor mix.
Bruce,
I am one of the few that say the natural rate of unemployment has risen to 7%. I agree with you in what you say. Labor has been taken for granted at a wage that doesn’t seem to recognize years of inflation and productivity growth. I still see jobs earning the same wage per hour that they did 20 years ago. For example, I was a financial manager for a sporting goods store back in the 90’s, We were paying our sales staff $8 to $13 per hour. 20 years later wages are still paying the same amount. It’s crazy.
However, that sporting goods store downsized into a small operation in the downtown when wal-mart came to town with a super store. Wal-mart took business from a lot of family owned businesses and then paid lower wages. And the town let them in.
I must be way off topic from your comment by now…
My view is that the natural rate of unemployment, and the natural rate of GDP and the natural rate of inflation are all established at the point where effective demand meets real GDP.
Thus, currently
natural rate of GDP = $16.1 trillion
natural rate of unemployment = 7%
On the other hand, the natural rate of inflation in theory is determined by the natural rate of unemployment. Since the natural rate of unemployment has risen, something to explore is whether a natural rate for inflation has fallen from around 3.0% to 2%
J. Goodwin,
Yes, a correlation could be tested. The key is to know the natural rate of unemployment for each business cycle. I have a calculation for that.
Look at the third graph at this link…
http://effectivedemand.typepad.com/ed/2013/03/an-interesting-graph-to-determine-the-natural-rate-of-unemployment.html
i write along the y-axis the rate of unemployment that signals the end of the business cycle. The rate of unemployment signaled by each business cycle could be tested against the inflation rates at those times.
How would you do it?
Well Ed I would want to turn that question on its head. What if we adopted a program that targeted real wage and employment numbers and so increased effective demand (if I understand that concept right) and so boosted GDP?
Now I understand there might be some trade-off in the form of nominal inflation but it is not at all clear to me that the increases in employment and the by definition post inflation metric of Real Wage would not increase labor’s share of subsequent effective demand even if total demand stayed steady.
Like I said much of your argument is over my head but from a ground level it seems that much of 50s and early 60s ecomomic and social polciy involved shifting resources and so the recipients of demand from the 5% to the 95%. Yet in ways that seemed to grow the overall pie in ways that the millionaires stayed such. I mean in retrospect who actually suffered when marginal tax rates were at 90%? Either individually or as a class? And did the nation suffer? Or GDP growth rates?
For what it is worth my take on all this is that classical models are whacked from the beginning, that cutting taxes rather than increasing ROI to capital creating a reinforcing mechanism that brings every more growth to the overall economy and so by Invisible Hand mechanisms to all in a “Rising Tide Lifts All Boats” instead just leads to stratagies that privilege consumption and display to investment. And as an example we could cite the evidence of ‘Old Money’ in the 50s which mostly embraced an ideal of old and where necessary shabby (outwardly) property, where status was maintained by living in a 200 year old house that belonged to the family and eating off crockery and silverware that belonged to Great Grandmother Abigail That is their display was the antithesis of ‘new’ and ‘flash’.
It seems that people forgot one of the lessons of the Great Gatsby which was that Old Money didn’t need to play New Money games, even as they enjoyed the spoils as just part of their due. Because the goal of Old Money was always to preserve capital and its natural growth rather than go for the quick gain. And mostly they didn’t begrudge the crumbs that fell off their tables to the servitor class. At least openly, it is not like the fifties were the great era of class warfare.
Except perhaps on the part of the New Rich. Like Hollywood actor Ronald Reagan and the Conglomerate Builders ultimately turned to Hedge Fund Billionaires types. Who like Gatsby might have stung at the social rebuffs from the Old Rich but who were determined to surpass them at whatever cost. Which cost inevitably came from the lower 99%.
But returning to the point, what if we simply rejected the strategies that have the New Rich vastly building fortunes that make the Old Rich look like paupers under the assumption that “wealth is wealth and the Invisbile Hand will take care of equity” and just embraced economic structures that directed returns on productivity more towards labor than capital (note I reject the concept of “redistribution” in this context).
As I have said before maybe I am just missing your argument but it seems strangely accepting of current distribution models that choke off labor’s share of what was once thought of a labor productivity. And so sees higher unemployment as a by product rather than a cause of that drop in effective demand.
Ed please Ed-icate me. Because I want to learn. Although I don’t promise to agree on every point.
Was the 50s/60s “economic policy” or were these “social programs” (New Frontier/Great Society) and technology/infrastructure programs (Defense Highways/DARPA) that had incidental economic impacts?