Unemployment and inflation once again…

The public discussion about inflation and unemployment appears to me to be substantially awry. It appears to incorporate two, and only two, lessons from history.

The first of these lessons is that pushing the unemployment rate below the level corresponding to full employment leads to strong upward pressure on inflation. The second of these lessons is that once inflation becomes embedded in expectations, the unemployment rate needs to be substantially elevated above the full employment rate for inflation to fall.

Even a moment’s thought, however, leads one to recognize that these two lessons are in enormous tension. If it requires substantial elevation of unemployment to wring inflation out of the system, then is it reasonable to also think that small undershoots of unemployment below the full employment rate can produce a significant acceleration in insulation? It might—the world is a surprising place. But that is certainly not the way to bet.

So where do these two lessons come from? The first comes from the 1970s. The second comes from the 1980s. During the Volker disinflation of the 1980s, it indeed required substantial elevation of unemployment to wring inflation out of the system, thus falsifying the hopes and predictions of rational-expectations economists such as Robert Lucas. And during the 1970s, inflation marched upward in fits and starts even in the absence of any substantial persistent inflationary gap between the unemployment rate and the full employment level.

Looking at the 1980s alone can justify the second lesson—that inflation is not very responsive to the unemployment rate. Looking at the 1970s alone can justify the second lesson—that inflation is very responsive to the unemployment rate. But looking at both creates a puzzle. And the most probable resolution of the puzzle is that the rise in inflation in the 1970s had other causes than an overheated, high-pressure, low-unemployment economy: the 1973 Yom Kippur Arab-Israeli War; the 1979 Iranian Revolution; the productivity slowdown of the 1970s that forced firms to raise prices by more in order to provide workers with their expected nominal wage gains.

Thus it seems to me more likely than not that the Federal Reserve’s current fear of a high-pressure economy is based on a misreading of a historical experience a generation and a half past. But those who might dissent from this policy—such as President Neel Kashkari of the Minneapolis Regional Federal Reserve Bank—do not command a majority on the Federal Open Market Committee. Kashari, however, in his eloquent “The Fed should not move too quickly to raise rates,” notes that “the US recovery took place after the Federal Reserve undertook extraordinary monetary policies.” He continues:

While some economists predicted these policies would lead to runaway inflation, the opposite has happened: inflation and wage growth have been surprisingly low. … With unemployment even lower now, why is wage growth so slow? Labour markets in other advanced economies shed some light on what is happening in America. … It could be that the 3.9 per cent measure does not capture the true slack in the labour market and that additional, hidden slack explains today’s modest wage growth. A better measure of labour market tightness appears to be the employment-to-population ratio of prime age workers, those aged 25 to 54 years old. … If you look at international comparisons, there is an astonishing contrast between the US and other developed economies. The percentage of prime-age Americans who are working has been declining during the past few decades, while the same ratio has climbed to new highs in the UK, Canada and Germany. …

Economists offer various theories. … Americans are addicted to drugs; too many have criminal records; workers do not have the skills needed for the available jobs. … The rise of Chinese manufacturing and of automation should affect other advanced economies as much as they do the US. …

The truth is we don’t know how much slack still remains in the US labour market. But international labour markets offer a hopeful sign.

This analysis has important implications for monetary policy. It suggests that as U.S. interest rates return to normal levels, policymakers should shift only to a neutral policy stance, and not move too quickly until we see more evidence that wages are climbing and that we really are at maximum employment.