Despite Tasci and Ice, I Still See an Increase in Structural Unemployment

[Update: Corrected an error in my analysis, though it oddly turns out to have very little effect on the relevant results.  Corrections are in italics.  I had fit the equation with AR(1) for the wrong time period, ending in 2005 instead of 2014.  Note that all fits should now be 12/2000 to 6/2014, the period of available JOLTS data.]


Back in 2010, there was a jump in US job openings (from an extremely low level) that was not accompanied by a commensurate decline in the unemployment rate.  Some saw this pattern as an indication of increased structural unemployment, with job openings becoming harder to fill from a given pool of unemployed.  At the time, I argued that it was not so:  job openings arise, and it takes time for them to reduce the unemployment rate; necessarily, there is a period when the unemployment rate remains higher than what would earlier have been associated with that number of job openings.   Then in 2012, I changed my mind.  A closer look at the data, including the additional two years that had passed, showed that, for a given number of job openings, the amount of hiring had declined.  That shift in the “matching function” suggested a change in the underlying relationship between unemployment and job openings, not just a temporary dynamic effect associated with the time it takes to fill new openings.

Recently some research has come out of the Cleveland Fed (cited approvingly by Paul Krugman) purporting to show that I was right the first time.  Specifically, Murat Tasci and Jessica Ice conclude that “there is no shift” in the Beveridge curve (the empirical relationship between job openings and unemployment).  They show that, in the years since that initial jump in job openings, the unemployment rate has fallen faster, and vacancies (job openings) have risen more slowly, ostensibly leading them back to the relation they had before the apparent shift in 2010.

I must say, first of all, that I don’t quite see their charts even appearing to show what they claim.  It’s true that, in vacancy-unemployment space, the point for 2014Q2 is very close to the point for 2008Q3; so, in a sense, any shift that was purported to have happened after 2008Q3 would now seem to have been an illusion.  But when I look at their chart, it looks like the shift actually happened between 2008Q2 and 2008Q3, when the unemployment rate rose and the vacancy rate failed to fall.  For the first two quarters of 2008, the not-yet-Great Recession looked much like the previous recession; then in 2008Q3 it appeared to shift to a new locus.  That apparent shift has not been reversed.

Comparing recent experience to the previous business cycle, it’s clear that we’re seeing a very different pattern this time around, not just in the intensity of the recession but also in the relationship between vacancies and unemployment.  Tasci and Ice have perhaps succeeded in demolishing the view that the large increase in vacancies in early 2010 represented a shift in the underlying relationship, but to my mind, that view has always been a straw man.  In any case it’s not a view that I ever held:  my research seemed to suggest changes in August 2006 and July 2010, the latter happening just after the alleged jump, not before or during.

Anyhow, in the light of the recent work, I decided to update my research, and, as my title suggests, my overall view hasn’t changed from 2012, though the details are a little different.  In my 2012 post I presented a model of the Beveridge curve, and my updated results can be described in terms of that model, but for the sake of universality I’m going to present them in a more agnostic way.

Start with the conventional “matching function,” which gives new hires as a function of unemployment and vacancies.  Using the JOLTS data (and using the absolute levels of hires, openings, and unemployment, as I did in my 2012 post), we can try to fit a matching function of the from lnH = a + b*lnV + c*lnU.  When I do this, I invariably get a negative value for c (regardless of specification details such as the inclusion of terms for autocorrelated residuals).  No plausible theory of the matching function gives a negative value for c.  (Surely it’s easier, not harder, to find people to hire if there are more people looking for jobs.)  So I re-fit, leaving out the U term.  (To put this another way, I’m fitting the equation with the constraint that c is non-negative, and I find the constraint to be binding.)

So I fit the equation with c=0, and I get a=4.52 and b=0.48, which would imply that hires are approximately proportional to the square root of vacancies, the same result I got in 2012.  Also as in 2012, I find that the residuals are autocorrelated (a Durbin-Watson statistic of 0.5, far from the ideal 2.0), presumably because the relationship has shifted over time.  So again I fit with an AR(1) term, and again I find that this gets but this time it is not sufficient to get rid of the Durbin-Watson problem. (The Durbin-Watson statistic goes to 2.9, still far from where it should be.)  So I added an MA(1) term and an AR(2) term, and this finally seems to be enough to handle the serial correlation problem.  This time, with the AR(1) term ARMA(2,1) terms, a=5.71 a=5.68 (although this isn’t very meaningful because the value of “a” is effectively shifted by the AR(1) term ARMA(2,1) terms), and b=0.34 b=0.33, which would imply that hires are approximately proportional to the cube root of vacancies (but in a way that shifts over time).

The interesting part, though, is what the residuals look like, so here they are:

[Note: This is the corrected chart.  The picture that originally appeared here is still up on Twitter and looks pretty similar.]

A couple of things are pretty clear about this picture.  First, there was a shift that took place between 2005 and 2008.  (The shift seems to be gradual, but given the amount of noise, it’s plausible that the shift could have happened in certain particular months, or even in just one particular month.  From the chart, the most decisive part of shift seems to happen between November 2007 and January 2008, which, probably not coincidentally, was also the turning point of the business cycle.)  Second, the shift does not appear to have been reversed.  (If you look closely, you might see another shift in 2010, which then seems to be reversed in 2013, but both the shift and the reversal could easily be noise, and in any case the original 2005-2008 shift has clearly not reversed.)

So here’s my conclusion:  something really did happen to make the Beveridge curve shift, and it was a persistent change.  Whether it was genuinely “permanent” we of course don’t know yet (since the current business cycle, one hopes, has a way to go, and the shift could be reversed later in the cycle), and whether it was truly a “structural” change is a question that is above my pay grade.  But I’m going to go with my best guess based on the available data and say that it looks like there was an increase in structural unemployment associated with the 2008 recession (or with what preceded and/or followed it).

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product

Stochastic Dynamic Inefficiency, Secular Stagnation, and the Natural Discounted Growth Rate

(I could have put a "wonkish" warning at the top, but come on, just look at the title!)

Let's start with the concept of the natural real interest rate, which is already ubiquitous. The real interest-rate is the interest rate corrected for expected inflation, and the natural real interest rate is the real interest rate consistent with price stability.  (I leave the definition of price stability ambiguous because it depends on your theory of the price level and inflation, which is a whole 'nother blog post.)

Now market monetarists like Scott Sumner and Nick Rowe point to a deficiency in the natural real interest rate concept: the natural real interest rate depends on the expected real growth rate. And monetary policy affects the expected real growth rate, so if policymakers try to set the actual interest rate equal to the natural rate, they are chasing a moving target. To me, this criticism suggests that the appropriate approach is to adjust the nominal interest rate not for expected inflation but for expected nominal growth. (While we're at it, we can also replace "price stability" with "nominal growth stability" and be done with our futile attempts to measure the aggregate price level.)

Most economists think that the natural real interest rate is normally positive. I have my doubts, but never mind, because I'm ditching the whole concept. Once we start correcting for expected normal growth rather than expected inflation, we are clearly not dealing with a natural rate concept that can be presumed to be normally positive.  If we are talking about a risk-free interest rate, then the need for physical capital returns to compensate for risk would make it very hard to achieve a long-run growth rate [an equilibrium with the interest rate] as high as the [growth] interest rate, let alone higher. To come up with a number that's usually positive, I suggest that we reverse the sign. Instead of talking about a "natural growth-adjusted interest rate," let's talk about a "natural discounted growth rate."

We can also talk about an "actual discounted expected growth rate."  (The discount is "actual," determined by the observable interest rate, but the associated growth rate is only "expected" because it is not known with any confidence when the interest rate is set.) If the actual rate equals the natural rate, you get a normal employment level and nominal income growth stability (or price stability, if you insist). If the actual rate is higher, you get accelerating inflation. If the natural rate is higher, you get depressed economic conditions, with excess unemployment and deflationary pressure, if not actual deflation. (Wicksellians, please recall that I have reversed the signs compared to the usual natural rate theory.)

Now that I've defined the natural discounted growth rate, I can define "secular stagnation" in the context of an NGDP target. Secular stagnation means that the natural discounted growth rate exceeds the growth rate of the NGDP target path.  In other words, the target path would require a negative nominal interest rate.  Under a level targeting regime, an attempt to pursue such a path will result in either monetary instrument instability or a "zigzag" growth pattern in which recessions alternate with inflationary catch-up periods. Under a growth rate targeting regime, you'll just keep missing the target from below, much like most of the developed world's central banks today. 

But if you play with the numbers, you can probably convince yourself that secular stagnation, by my definition, seems unlikely. A reasonable NGDP target path growth rate is maybe 5%.  Do we really think that the potential growth rate exceeds the natural interest rate by more than five percentage points? It's remotely conceivable, but my guess would be that our problem today is not secular stagnation (in this sense) but a flawed monetary policy regime.

Now if the target nominal growth rate (and the associated possibility of secular stagnation) is one of our bookends for the natural discounted growth rate, the other bookend is pretty clear: it's zero. Some readers will immediately recognize zero as the criterion for dynamic efficiency. Ignoring the issue of risk for a moment, an economy with a strictly positive natural discounted growth rate would be dynamically inefficient. Overall welfare could be improved by instituting a stable Ponzi scheme that transfers consumption backward across generations.

Does my assertion that the natural discounted growth rate is almost certainly strictly positive imply that we actually live in a dynamically inefficient economy? In an important sense, I think it does.  The thorny issue here is risk, and some will argue that the relevant interest rate for dynamic inefficiency is not the risk-free rate.  But I disagree.  The US government can produce assets that are considered virtually risk free, and a stable Ponzi scheme operated by the US government could presumably produce such assets yielding any amount up to the growth rate.  At today’s Treasury interest rates, which are clearly less than expected growth rates, marginal investors are (we can presume, since the assets are freely traded) indifferent between these low-yielding Treasury securities and investments that represent newly created capital.  So, given the risk preferences of the marginal investor, the government could, by operating a stable Ponzi scheme, be producing assets that have a higher risk-adjusted return than newly created capital.  Given the risk preferences of the marginal investor, it’s inefficient for the government not to be producing such assets.

It’s important to recognize that, under a typical scenario, the marginal investor will end up worse off, in a material sense, from earning the growth rate, compared to earning the actual return on capital.  In a material sense, the economy is dynamically efficient.  But the concept of risk preferences models a subjective good – call it “security” – and we’re not producing enough of this good.  The history of interest rates and growth rates suggests that we have seldom produced enough security, but the deficiency today is clearly worse than usual.  

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product. 

Taper Paradox

Suppose you get invited to a party.  You don’t expect it to be a very good party, because the mood in town is pretty bleak:  most people likely won’t even show up, and those that do won’t be much fun.  So you decide, “Unless I hear something good about this party, I’m just going to stay home.”  

Then you get a call from a friend who is at the party, and he convinces you that it’s better than expected and you should come.  You assure him you’ll be there.  So you start getting ready, but you’re still in no hurry to get to the party.  

Then you get a call from the host:  “Joe tells me you’re coming.  That’s great.  Can I ask you a huge favor?  If you have some rum, can you bring it?  The party is starting to get lively, but we’re going to run out of rum soon, and the liquor stores are closed.  If someone doesn’t bring some rum, we may have to take away the punch bowl earlier than expected.”  You don’t have any rum, unfortunately, but you know you can get to the party quickly if you hurry.  Assuming you like rum punch, does the knowledge that the punch bowl might be taken away early make you more or less eager to get to the party quickly?

I may have strained the traditional punch bowl metaphor here, so let me try to tell the more complicated story in economic terms.  According to some theories, national economies (and the world economy, perhaps) exhibit multiple equilibria.  If everyone expects everyone else to spend a lot, then it’s rational to spend a lot (e.g. buy a new car in anticipation of keeping or getting a job, build a factory in anticipation of selling a lot of output, etc.).  If everyone expects everyone else not to spend a lot, then it’s not rational to spend a lot.  So depression and recovery become alternative self-fulfilling prophecies.  As FDR famously put it, “The only thing we have to fear is fear itself.”

Normally, though, at least from the period from 1940 to 2007 in the US, fear itself isn’t a real problem.  Why not?  Because these equilibria depend on the interest rate, and the Fed controls the interest rate (at least in the short run), and usually the Fed can make the interest rate so low that the “bad,” low-demand equilibrium is no longer feasible.  A lot of projects that normally wouldn’t be worth doing (or purchases that wouldn’t be worth making) when demand is weak, become worthwhile even with low demand when they can be financed very cheaply.   But if people do these projects and make these purchases, demand won’t be weak.  So if the Fed keeps interest rates low enough, or even just credibly threatens to keep interest rates low enough, the low-demand equilibrium reduces itself to absurdity.

But recently we have faced the problem that interest rates can’t go below zero.  So we are back in FDR’s “fear itself” world, with multiple feasible equilibria.  In the low-demand equilibrium, the Fed struggles by keeping interest rates as low as it can get them, but that isn’t enough.  Barring more aggressively creative policies than the Fed has been willing to implement (retroactive NGDP level path targeting, anyone?), it just has to wait until people get more optimistic.  Or until people expect other people to get more optimistic.  Or until people expect other people to expect other people to get more optimistic.  Or until…well, you get the idea.  There’s reason to expect this optimism to come eventually, because capital depreciates (e.g. cars wear out, a growing population needs new places to live, etc.), so there will eventually be reason to expect higher demand.  But, as the Japanese have learned, the wait can be a very long one.

There’s a trick here, if you’re a prescient investor/entrepreneur.  Someday the demand will be back.   Someday the optimism will be back.  And the Fed will no longer have to struggle by keeping interest rates at levels that seem ridiculously low but still aren’t low enough.  But right now interest rates are still very low.  Suppose you could guess when the economy was about to recover and finance a project at the low “bad equilibrium” interest rates while subsequently benefitting from the demand that will come when the economy recovers.  You’d stand to make a lot of money.

So if, for whatever reason – even if it’s for no real reason at all – there’s a shift toward optimism, it’s like yelling fire in a crowded theater.  (If you don’t like my “punch bowl” clich矇, I have plenty of others.)  Everyone wants to be that prescient investor/entrepreneur who finances cheaply in the bad equilibrium and gets windfall demand in the good equilibrium.  Once you make your mind up to go to the party, you want to make damn sure you get there before the punch runs out.  As we say in wonkspeak, systems with multiple equilibria often exhibit highly nonlinear dynamics.  There is a tipping point, a straw that breaks the camel’s back.  (Really, plenty of others.)

What happens, then, when the Fed starts to talk about tapering its bond purchases?  It depends.  If we take the camel’s back to represent economic depression, there are (at least) three possibilities.  If the camel’s back is already clearly broken, the tapering talk should already have been anticipated, and it will have little effect.  If the camel’s back is still strong, then the tapering talk will make it even stronger, fortifying the depression against the already ineffectual straws of optimism.  But suppose the camel’s back is just in the process of breaking: some people have concluded that it’s definitely not going to hold, some are getting very close to that conclusion, and some still need convincing.  What happens then?

I’m pretty sure it’s ambiguous, depends on how you set up and calibrate the model, etc..  I imagine someone has tried to model this formally, but I’m too lazy for that (and being a private sector economist, rather than an academic, I don’t get paid to do theoretical modeling).  In any case, it seems quite plausible to me that, under reasonable conditions that may approximate those we have faced over the past month, tapering talk could accelerate the shift from the bad equilibrium to the good one.  That acceleration would be consistent with the observation that the dramatic moves in the bond market have had only a little apparent impact on the stock market.  (If people are discounting the same cash flows at a much higher discount rate, stock prices should have gone down considerably, but they’ve barely declined at all, which suggests that expected cash flows have risen.)

Note that tapering talk implies that (1) the Fed, which may have better information than we do, is more optimistic than we thought and (2) if you were nearly convinced that the depression is over, you had to make up your mind and act on your belief as quickly as possible, or you would lose the opportunity to profit from it.  Given the existence of multiple equilibria, it’s quite possible that the Fed’s tapering talk has had the paradoxical effect of accelerating the recovery, which would explain why markets now seem to expect the Fed to start raising short-term rates sooner than the Fed itself has implied.

Do I think the Fed did the right thing by strategically engaging in verbal tightening at just the time that it would have a paradoxical effect?  No.  For one thing, the Fed obviously didn’t anticipate this response, and in any case the interpretation I’ve suggested here is highly speculative.  And even if my interpretation is right, and even if the Fed is cleverer than we think and actually intended it this way, I still don’t think they did the right thing.  Accelerating the recovery is a good thing, all other things equal, but it’s not the most important thing.  The most important thing is for the Fed to assure us, in no uncertain terms, that it will continue to support the recovery until there is no ambiguity left.  My guess is that, given what I imagine the Fed’s preferences to be, starting to tighten (verbally) now will turn out to have been the right thing to do.  But my guess, even if it is the best guess based on the information I have, is subject to a lot of uncertainty.  From the point of view of the recovery, mentioning the taper last week was a risky move, and even if the risk pays off, I don’t think it’s a risk the Fed should have taken.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product. 

Why Doves Are Really Hawks

Machismo is a type of commitment mechanism. 

If you’re a perfectly rational nerd, people will always expect you to do the rational thing.  You won’t be able to make credible threats unless it would be rational to carry out the threat.  And it seldom will be.  After all, how often is it really rational to whoop someone’s ass?

On the other hand, if you’re a tough, macho badass, people will always expect you to do the tough, macho badass thing.  You’ll always be able to make credible threats, because carrying out threats is always the tough, macho badass thing to do.  And since the threats are credible, you mostly won’t have occasion to carry them out.

This principle has a traditional application to monetary policy.  If your central banker is a perfectly rational nerd, he’s going to let the inflation rate get too high, because he won’t be able to make a credible threat to cause a recession.  People won’t expect him to carry out the threat, because in most cases it won’t be rational to carry out the threat.  After all, how often is it really rational to cause a recession?

On the other hand, if your central banker is a tough, macho badass, he’s not going to let the inflation rate get too high, because he will be able to make a credible threat to cause a recession.  People will expect him to carry out the threat, because causing a recession is the tough, macho badass thing to do (for a central banker).  And since the threat is credible, people will keep their prices down, and he won’t have to carry it out.  (OK, the economics is a little more complicated, but that’s the general idea.)

So what kind of central banker do you want if you hope to keep the inflation rate from getting too high?  Obviously you want a tough, macho badass.  You want the kind of central banker that likes to pick up small animals in his talons so that he can crush them to death and serve them for dinner.  You sure as hell don’t want the kind who just likes to fly around looking pretty and making cute cooing noises.

That theory made a lot of sense in the 1980’s, but the world has changed.  The inflation rate hasn’t been too high for 20 years.  We are in the middle of a minor depression, and the way to get out of it is to threaten inflation.  Tell people they had damn well better start doing something useful with their cash or else, as soon as you get a chance, you’re going to make its purchasing power start evaporating.  Of course, when the time comes, it won’t be rational to carry out that threat.  If you’re a perfectly rational nerd, the threat won’t be credible.

So what kind of central banker do you want if you hope to get out of this depression?  Obviously you want a tough, macho badass.  You want the kind of central banker that likes to pick up small animals in his talons so that he can crush them to death and serve them for dinner.  I’m certainly no expert in ornithology, but it just seems to me that “dove” is not the right term for that kind of central banker.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product. 

Inflation vs. Price Level Targeting

I don’t have time for a real blog post, but here’s a quickie in an attempt to keep this blog alive.

Dave Altig and Mike Bryan of the Atlanta Fed’s Macroblog argue here that it wouldn’t make much difference if the Fed were doing price level targeting (in which the future target path stays fixed even when you miss a target, so you need catch-up inflation or catch-up disinflation) rather than inflation targeting.  Their evidence is mostly from a chart like this (my replication using monthly data, which you can confirm looks fairly similar to theirs which appears to use annual data):

Quoting from their blog post:

Consider the first point on the graph, corresponding to the year 1993….This point on the graph answers the following question:

By what percent would the actual level of the personal consumption expenditure price index differ from a price-level target that grew by 2 percent per year beginning in 1993?

The succeeding points in the chart answer that same question for the years 1994 through 2009.

In my case, as I said, it’s monthly, and it goes all the way to 2012, but the idea is the same.

OK, fine.  So here it looks like a price level target would have produced roughly the same results as the Fed’s (unofficial until January 2012) inflation target, and whether it would have undershot or overshot depends on when you start the target path.  In particular, people who argue that we are undershooting right now don’t seem to have much of an argument unless they start the target path in 2008 or later.

BUT…

The problem with this chart is that it uses the headline PCE price index, whereas during most of this time (until January 2012 when the official inflation targeting policy was introduced), the Fed was perceived to be targeting core PCE inflation (excluding food and energy, that is), not headline inflation.  Price-setters were making their decisions largely under that assumption.  It makes no sense to go back to 1993 and set up a target path using the headline price index when that index was irrelevant to the policy that the Fed seemed to be following at the time.

Moreover, targeting the price level using the headline price index is a bad idea anyhow.   If you're going to use a price level target (and I do think it would be better than an inflation target), then you don't want to use a price index that will be subject to shocks that are volatile but persistent. A one-time increase in the price of oil should not require a subsequent compensating decline in other prices to offset it (nor should a one-time decrease in the price of oil require a subsequent burst of inflation to offset it). Theoretical arguments would suggest using an index of sticky prices, but the core is a reasonable approximation.

Here’s what my chart above looks like when you use the core PCE price index instead of the headline index.

Very different.  By this measure we are undershooting now no matter when you start the target path.  And unless you cherry-pick the starting point in 2003 or 2011, the size of the undershoot is not insignificant.  If you compare to the 1990’s, the Fed was already slightly behind when the Great Recession began, and they have fallen further and further behind since then.  Price level targeting, using the core price index, would require the Fed to promise a significant amount of catch-up inflation in the coming years.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

James Medoff, Stagflation, the Phillips Curve, and the Greenspan Boom

James Medoff, my thesis advisor in graduate school and later my collaborator and business associate, died on Saturday, September 15 after a long struggle with multiple sclerosis.  In the field, he was probably best known for his work on labor market institutions, and particularly for his work with Richard Freeman on the impact of unionization.  But by the time I started working with him, most of that was in the past.  I was a student of macroeconomics, not labor economics, but I was intrigued by a paper he had written with Katharine Abraham entitled “Unemployment, Unsatisfied Demand for Labor, and Compensation Growth, 1956-1980.” It seemed to provide a critical missing piece in the puzzle of macroeconomics.

Why was there stagflation (stagnation and inflation at the same time) in the 1970’s?  When I was in graduate school, there were two popular (complementary) explanations.  First, the Fed had been too easy because it didn’t adequately account for the way inflation expectations would become ingrained.  (In the cartoon version of this idea, the Fed goes from believing in a static downward-sloping Phillips curve to realizing – much too late in the game – that the long-run Phillips curve is vertical, but in reality there were certainly some steps inbetween.)  Second, there were oil shocks, shocks to aggregate supply which drove prices up and employment down.  A third explanation you might also hear was that the Fed had responded to political pressure from the Johnson and Nixon (and possibly Carter) administrations and loosened at the wrong times.

Doubtless there was something to all of these ideas, but the Medoff-Abraham paper suggested a completely different explanation.  Essentially what it said was that there was not nearly as much “stag” in the stagflation as we thought.  The labor market, it suggested, had been booming during much of the 1970’s despite the appearance of high unemployment.  The implication was that the unemployment of the 1970’s was largely “structural” (at least that’s the term used in debates about today’s unemployment), and once you realized that, the accompanying inflation shouldn’t surprise you.

When I took James’ graduate course in 1989, this idea was particularly important, because the situation was beginning to reverse itself.  The plateau in structural unemployment lasted from maybe 1975 to maybe 1987, and after that it began to decline.  By the time I graduated, in 1994, this decline was well underway, and our data were suggesting that the US economy could support considerably lower unemployment rates without sparking inflation.  James was invited to the Fed’s meeting of academic consultants that year to make the case for lower unemployment, and I went along to help and observe the discussion.  As I recall, there were about 10 people at the table, and James was the only one saying that it was OK to keep interest rates low and let the unemployment rate fall further.

Naturally, rather than listen to a single maverick, the Fed kept raising rates, and maybe that was for the best, since the recovery turned out to be stronger than most people (including us) had expected.  But over the next few years, something unusual happened.  The unemployment rate kept coming down, and the inflation kept not happening, and now it was Alan Greenspan himself, not some out-of-the-mainstream labor economist from Harvard, who was insisting (against some substantial resistance) that it was OK to keep interest rates low and let the unemployment rate continue falling.

Did James Medoff ultimately influence monetary policy, and was he therefore partly responsible for the boom of the late 1990’s?  Who knows?  If I had Alan Greenspan’s ear, I might ask him.  At his funeral, James’ daughter Susanna said that, in fifth grade, she had wanted to dress up as her father for “Dress as Your Hero Day,” but the teacher wouldn’t let her, so she dressed as Alan Greenspan instead.  In those days, a lot of adults may have considered Greenspan a hero, but I doubt many other fifth graders did.  For the record, I still think Greenspan did a remarkable job with the macroeconomic aspects of monetary policy, and his hero status (since rescinded by most commentators) was not without justification.

In any case, I feel that the research I mentioned is relevant today in a couple of ways.  For one thing, the saga of structural-vs-cyclical unemployment goes on today.  Using techniques similar to those used by Abraham and Medoff, my best guess is that, after the long decline that began around 1988, structural unemployment reached a trough in 2005 and has been rising since then.  (However, I see no particular evidence of a discontinuous increase during the Great Recession, or immediately before or after, and the increase since 2005 has not been particularly rapid, so I don’t buy the view that “our problem is structural.”)

Another way the research is relevant is that it reframes the 1970’s.  By the end of the 1970’s, most economists were convinced that, as textbooks put it during my undergraduate years and maybe still do, “the long-run Phillips curve is vertical.”  In other words, there is no long-run tradeoff between unemployment and inflation.  In the minds of most economists this conclusion was necessitated by the experience of the 1970’s, during which it seemed to become obvious that higher inflation was not generally associated with lower unemployment.  But if much of the problem of the 1970’s was structural, then the conclusion is not so obvious.  Perhaps, conditioning on the structure of the labor market, a downward-sloping Phillips curve still exists, even in the long run.  Indeed, more recent evidence suggests that there is such a tradeoff after all, at least at low inflation rates.

This is important because the US seems to be in the middle of that tradeoff right now.  If you believe there is no tradeoff, if you believe the long-run Phillips curve is vertical, then it's hard to explain how there's still any inflation at all after almost 5 years during which we had first an extremely deep recession and then a painfully slow recovery that has left output still well below any reasonable estimate of the economy's potential.  After 5 years, we should surely be making our way toward the long run, that vertical Phillips curve at full employment. If we're not, it must be because demand is astonishingly weak, and that astonishingly weak demand should be associated with an inflation rate that falls lower and lower until it becomes negative. (This is the flip side of an overheated economy that produces ever-accelerating inflation.) But that isn't happening. Instead we're seeing something that looks a little bit like the old-fashioned downward-sloping static Phillips curve, where low, but not necessarily falling, inflation rates are associated with persistent excess unemployment.

I admit this isn't what I expected. I wrote a blog post a couple of years ago predicting deflation. Even after having questioned the conventional wisdom, I had found it too strong to resist. The vertical long-run Phillips curve, I thought, might not be quite right, but it was "a close enough approximation," and if I denied this, I'd face excommunication from the Church of Macroeconomics. Deflation was coming, I thought.  I was wrong.

I never got a chance to discuss this question with James. During his last years he found it increasingly difficult to think and express himself clearly, so it's unlikely we could have had a productive discussion. But I can imagine what he would have said 20 years ago. He would have talked about his contacts in industry and how they weren't about to destroy morale by cutting wages, even if the economy stayed weak for several years. After some discussion I think we would have come to the conclusion that the vertical long-run Phillips curve was actually a pretty crummy approximation. That's certainly what I think now. I'm going to have to pay more attention in the future to what Hypothetical James Medoff has to say. He lives on.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

The Fed and Fiscal Responsibility

If the US goes off the fiscal cliff – that is, if tax increases and spending cuts go into effect in 2013 as currently scheduled – can monetary policy actions offset the macroeconomic impact?  Ben Bernanke doesn’t think so – indeed he’s certain they can’t – and he has said as much.

But on some level he must be wrong.  True, it’s hard to think of any feasible monetary policy action that would both be strong enough and have a sufficiently quick impact to offset the fiscal cliff directly.  But what matters more for monetary policy is not the direct effect but the effect on expectations.  Surely the Fed could alter expectations of future monetary policy in such a way that the resulting increase in private spending would be enough to offset the decreased spending due to fiscal tightening.  Just think, for example, if the Fed were to increase its long-run inflation target.  If nothing else, a sufficiently large increase in long-run US inflation expectations would make the dollar sufficiently unattractive to result in an export boom that would offset the fiscal tightening.  More important, perhaps, it would make currency and Treasury securities less attractive to Americans and encourage them to do other things with their wealth, such as buying houses and durable goods and investing in productive capacity.

Of course that isn’t going to happen.  To get the Fed to do something as drastic as increasing its long-run inflation target, we’d need more than a fiscal cliff; we’d probably need something like a repeat of the 1930’s.  But at this point the Fed has substantial amount of flexibility even within the confines of its long-run target, because it hasn’t specified how that target would best be implemented.  It hasn’t said, for example, whether the target should be interpreted as a growth rate target – where policy constantly begins with a clean slate, ignoring previous missed targets – or a level path target – where policy always attempts to compensate for earlier misses and regain the original target path.  If the latter case prevails, the Fed hasn’t said whether the target path would be retroactive and if so how far back it would be retroactive (for example, choosing 2007 as a base year for the target path instead of 2012).  Moreover, while the Fed has affirmed its commitment to its dual mandate, it hasn’t said how its inflation targeting approach would interact with its employment mandate.

One way to implement the long-run inflation target would be as follows.  First, estimate the economy’s potential output path that was, as of 2007, consistent with maximum employment.  Then add to this a 2% inflation path starting from the 2007 price level.  Express the result as a target path for nominal GDP, and project that path into the future at the estimated future growth rate of potential output plus 2%.  Pursue this path as a level path target.

Because nominal GDP has fallen so far below the path that would, in 2007, have been consistent with 2% inflation at estimated potential output, this approach implies a very dramatic period of catch-up.  Essentially, the Fed would be committing to follow a very aggressive pro-growth, pro-inflation policy over the medium run as soon as it is able to get some traction on the economy.  But it would be doing so in a way that is consistent with its 2% long-run inflation target.

The effect on expectations would be quick and dramatic.  By promising either growth or inflation or both, the Fed would make hoarding cash (or other safe assets) look like a clearly losing proposition.  Depending on whether you expect inflation or growth, either your money will lose its purchasing power, or you will miss out on a lot of profits as real assets recover.  My guess is that, with this change in the medium-run outlook, the resulting increase in private spending over the short run would more than offset the fiscal cliff.  Your guess may be different, but in any case we’re talking about an impact considerably larger than what can be accomplished with the kind of changes in its balance sheet that the Fed typically contemplates now when it thinks about trying to stimulate the economy.  If Ben Bernanke were contemplating anything like what I am suggesting, he clearly wouldn’t be justified in being certain of his inability to offset the fiscal cliff.

OK, this isn’t going to happen either.  At least it’s highly unlikely.  Ben Bernanke isn’t going to have his “Volcker moment,” as Christina Romer called it, just in time to offset a huge tightening in fiscal policy.  And, with any luck, the tightening in fiscal policy won’t be as huge as current law prescribes:  after the election, hopefully, either one party will be in power, or Democrats and Republicans will be able to come to enough of an agreement to prevent disaster.

But the sad thing is that preventing disaster almost certainly means putting the US back on an unsustainable fiscal path – because there’s very little chance that Congress will be able to agree on a credible long-run fiscal plan at the same time that it agrees on a way to avoid going over the cliff in the short run.  Assuming that we do go over the cliff and that the Fed doesn’t offset the impact, the long-run fiscal results may not be much better, because the growth impact of the fiscal shock – allowing for hysteresis effects – will undo at least part of the improvement in the budget.  For those whose primary concern is fiscal sustainability, the best-case scenario would be that we do go over the cliff and that the Fed acts aggressively to offset the macroeconomic impact.

Again, it isn’t going to happen.  And that’s kind of sad.  The Fed’s timidity is creating a situation where the only realistic choices – for the moment anyhow – are economic disaster and fiscal irresponsibility.  Doesn’t that mean that the Fed bears some responsibility for the fiscal problems that are eventually likely to emerge?

  

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.