Model of Japan’s low inflation & need for higher labor share
I have been presenting a new model to explain the forces around inflation. (link1, link2)
Antonio Fatas poses a very good question. You can lower interest rates, but can you raise inflation?
“But if monetary policy is being successful we expect inflation expectations and growth expectations to increase. Both of these forces should push long-term interest rates higher not lower! Something is fundamentally not working when it comes to monetary policy and it is either the outcome of some forces that the central banks are unable to counteract or”
I stop right there. For me, there are forces that the central banks cannot counteract. And the new model is revealing some preliminary mechanism to show how.
I applied the model to Japan’s situation of low inflation and low nominal rates.
- Natural real rate is negative = -0.6%
- Effective labor share = 70%
- Capacity utilization optimized at 5% unemployment
- Adjust exponential equation of core inflation to allow for deflation, i = 0.036 * e(-13*net profit rate) – 1%
Here is the model assuming a 2% inflation target…
Two things to note here…
- The central bank nominal rate (solid red line) stays at the zero lower bound almost up to the natural limit of capacity utilization (vertical green line)
- Core inflation hovers on the edge of deflation the whole time up to the natural limit.
Even by keeping nominal rates low, inflation still stays low. Antonio Fatas talks about forces. Here we see the forces at work.
Now I solve for the inflation target that brings monetary policy into balance with the forces.
Look at the horizontal dashed green line of the inflation target. It now sits at -0.3%. The model shows that a mild target of deflation is the best monetary policy to balance the forces affecting inflation.
Also note that the base central bank nominal rate sits at the zero lower bound all the way to and past the natural effective demand limit. (vertical green line)
The model reflects the situation in Japan. Loose monetary policy cannot counteract the forces that want to go into balance at a mild deflation level.
Keep in mind that the model probably needs some tweaking to get coefficients right, but the model can explain forces that Antonio Fatas mentions.
The success of Abenomics depends upon raising labor share. A higher labor share would raise the balanced inflation target. I and others have said this from the beginning. This model gives a logic behind the view..
Either adjust for population changes or get out of here. Period. Maybe the problem is, inflation is already at a proper level in Japan. I was over there and don’t see any recession. This is what happens when you don’t adjust for demographics. Trying to boost inflation may be what causes future recession as it contracts spending.
This is the same function inside US labor markets where job growth is outstripping “appeared” GDP due to the Boomers retirement boosting future job growth.
The problem is, people refuse to follow demographics. In the 2020’s the US will have to grow faster for example, well duh.
John,
I adjusted for demographics by making the natural real rate negative at -0.6%.
Edward,
Thanks for an excellent article. I appreciate all of the work.
I suspect that it is nearly impossible to fully control inflation while suppressing wage inflation. This made more difficult now too because producers no longer depend as much on consumers from within their respective economies. The days of Henry Ford’s claim that workers must earn enough to buy the products that they produce are ‘decoupled’, naturally. And thus, much of what economists have learned from the past…no longer applies.
It is important to understand though that the objective of ZIRP and QE, and the like, extend beyond the stated objectives. Since the Reagan tax reforms, our government, and the FED of course, has been supporting investors, and at the expense of everyone else, in an effort to win the economic war which is being fought to own as much global market share as possible. Meanwhile, economists have been trying to make sense of what can’t be made sense of without revealing what is essentially a covert operation.
So, one must learn to view the world from a perspective that includes a sound understanding of the actual objective. Then, it becomes increasingly easy to understand a great many things.
Ray
Thanks Ray for your insightful comment… I agree with your views.
Maybe it is worth mentioning here too, that the long-term scheme for globalization has always included a recognition that wages in the advanced nations would need to stagnate so as to allow the rest of the world catch up, at least some. Back when globalization was first being considered, back when our likes used what were called ‘books’, hehe, the term ‘demographic dividend’ got quite a lot of use. This term being a nice of way saying…’cheap labor good’. But of course that brought about concerns about a ‘race to the bottom’ as the global labor pool expanded to include an almost endless supply of cheap labor. But, all things considered, the scheme has worked better than many of us expected.
And now, finally, a trade treaty with provisions to allow our gluttonous consumption habits as leverage to require trading partners to raise their standards, and possibly, or presumably, wages in the poor nations may rise at a faster rate. The point here being that wages in the advanced nations are now inextricably linked to wages elsewhere; and… that there is extremely valuable potential in the TPP that has been mostly ignored. Connect if you will, the excess liquidity that is always present in ‘bubbles’ to the lack of investment in the places where it is needed most, and the TPP starts to make quite a bit of sense.
And Uruguay, with help from M. Bloomberg, just beat Phillip Morris in one of the ISDS cases that has so many, so concerned.
Ray
Thanks for adding these ideas too Ray…gluttonous consumption is not a good goal. It sounds good for business. They are motivated to invest. But the goal lacks wisdom.
Edward,
” They are motivated to invest. But the goal lacks wisdom” Yes, ’tis true, but that motivation is well understood, ROI, ‘vile insects’ and all of that. But these may well be propensities which simply need better ‘wisdom’. Yet those who we rely on for that type of wisdom, of the type that foresees the possibilities, well, they seem mired in outdated thinking. Take the recent study out of Ball State for example, and hold its overwhelming reason for job loss (productivity), against what Sanders campaigned on in regards to trade issues. How then are Sanders and his followers ‘progressive’. But then of course, yesterday’s progress is today’s status quo.