After Bernanke’s Jackson Hole speech a few weeks back I began a long rambling analysis with what I saw as the key revelation:
Pretty disappointing, but with one silver lining. We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation. That means no more “depression economics.” Let’s get costs down and we can get a faster economic recovery:
1. Payroll tax cuts (at the margin, employer only.)
2. Replace unemployment extended benefits with large lump sum payments to the unemployed.
3. Temporary (two year) minimum wage cuts to $6.50.
Of course this won’t happen, but it would promote faster growth if it did. They are things Obama could try.
I recall that my claim there was a “Bernanke put” at 1% inflation, and an implied promise to use QE to make it happen, raised a few eyebrows at other blogs. How things change in a month! After the most recent Fed statement this view has become something close to the conventional wisdom everywhere from the sophisticated FT:
The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle.
To the brash Wall Street Nostradamuses:
- What does he see now? The Fed just announced “we want economic growth, and we don’t care if there’s inflation… have they ever said that before?”
- What’s going to do well? EVERYTHING: stocks, bonds, gold etc. Stocks can’t go down that much, because the Fed is issuing a put. “You’ve gotta love a put.” (See more on the “Fed put” here.)
So the punditry seems to have arrived where I believe we’ve been all along—in a classical world where improved AS moves GDP in the “right” direction. But when I wrote those lines I did not fully anticipate the implications of this Fed policy. The term “classical world” is a bit misleading, as it implies a near-vertical AS curve. In fact, the SRAS is now relatively flat. And a flat SRAS combined with an inflation-targeting Fed leads to some peculiar policy implications that I haven’t seen anyone else discussing.
Imagine the standard AS/AD model. When AS shifts downward by one percent, you get a small (short run) increase in output and a small decrease in prices. In Krugman’s depression model, as formalized by people like Eggertsson, a decrease in costs can actually reduce output, by increasing expectations of deflation.
A model with an inflation targeting Fed and significant economic slack could not be more different from the Krugman/Eggertsson worldview. Now even a slight decrease in business costs can produce a dramatic rise in output. Call it a “large supply-side multiplier.”
To see why this occurs, think about what it means to target inflation. For example, consider a central bank with a 1% lower bound on inflation in a country where the inflation rate is already at the lower bound. If there is a threat of inflation falling further, the central bank will do enough QE to keep inflation expectations no lower than 1%. Now assume there in an increase in aggregate supply, shifting the SRAS line to the right. Normally, that would reduce inflation below 1%. But with inflation targeting the central bank won’t let that happen. They’ll do whatever it takes to shift the AD to the right by exactly the amount that AS has shifted right. Inflation will be unchanged, and the positive supply shock will increase output.
Here’s where it gets interesting. Think of the supply shock not as moving the AS to the right, but rather as shifting it downward (of course both changes occur.) Why does it shift downward? Because the cost of production declines. Let’s assume Obama does some things to reduce business costs. Say he cuts the minimum wage by 10%, and also cuts the employer share of the payroll tax by 2%. Assume these changes reduce business costs by 1%, shifting the SRAS 1% lower in the up and down direction (remember, this is still an increase in AS.)
What happens to output? Here’s the big surprise; the more correct Paul Krugman is about the SRAS currently being pretty flat, the larger the increase in output. I think he is much more correct about the “slack” problem than his conservative critics, although I also believe the structural problems are a bit larger than he seems to imply. Let’s take two cases, in one the slope of the SRAS is 1/3 and the other it’s 1/5. If the slope is 1/3, and the SRAS curve shifts 1% lower, then the Fed must do enough QE to move AD 3% to the right, in order to prevent a fall in inflation. If the slope is 1/5, the Fed needs to boost AD by 5%. I think you see where this is going. If the Fed is serious about preventing inflation from falling below 1%, and I think it is, we are suddenly in Andrew Mellon country. You get recovery by driving down business costs. Wages, real estate, auto parts from China, whatever. Don’t prop up wages, don’t prop up the property sector, don’t try to force China to raise its prices. And the biggest irony is that the more Krugman is right about the flat SRAS, the deeper into Mellon country we go.
Now of course I’m being a bit provocative here in my usual irresponsible way. Mellon also favored tight money, which I don’t. But I am doing it to make a point. Krugman’s arguing for exactly the opposite approach; get tough with China, help out people with mortgages, do demand side fiscal stimulus, not cuts in the employer share of the payroll tax. Indeed consider for a moment the implication of cutting the employee side of the payroll tax, which sounds better to those who live in a Keynesian demand-side world. With sticky wages it won’t have any immediate supply-side effect, but it will increase AD. Unfortunately, this will simply cause the Fed to delay its anticipated QE. Why? Because as people like me and Tyler Cowen and even Ben Bernanke have frequently observed, the Fed is the last mover in the stimulus game:
Well, in our short-term monetary policymaking, we are able to adjust for the conditions of fiscal policy, however they may be. I think fiscal issues are more important in the long-term sense because of the long-term obligations we have, for example, for entitlements. We have not found the fiscal situation to be a major impediment to our short-term management of monetary policy.
That’s right, he’s sort of saying; “You Congressman can play whatever fiscal games you’d like, but leave the determination of NGDP growth to the grown-ups at the Fed.”
Let’s suppose I oversimplified when I said they had a 1% target, a closer reading of the Fed’s minutes might imply something a bit more sophisticated. Arguably there is an intention to gradually raise the inflation rate to 2% over the next two or three years. Does that change my analysis at all? No, any inflation target will do, it doesn’t have to be a fixed target.
There is a faint glimmer of hope for the Keynesians if you assume the Fed has a 1% lower bound on inflation, has no intention to push it back up to 2%, but will gladly allow fiscal stimulus to push it back up to 2%. That would be a weird policy, and go against their statement that they eventually wanted to get inflation back to 2%, but it’s possible. But even then, in that best case, it would merely be an argument for fiscal stimulus, not an argument against austerity. And let’s face it; fiscal stimulus isn’t going to happen. I don’t think austerity will either, but there are at least some supply-side policies that the Republicans would support. It’s up to President Obama.
This result is so counter-intuitive that a visual metaphor might help. Imagine you’re playing a game with your child, where you stand in one room by the door, and she stands on the other side of the door. If she pushes one way, you push back so that the door doesn’t move. If you want the other person to push on the door, you must convince them that they shouldn’t let the door open into their room. That’s what we’ve been trying to get the Fed to do, push back against sub-1% inflation. Now they’ve finally committed. So we are free to push prices as low as we want with supply-side policies, knowing they will push back with demand-side policies to prevent prices from falling. If the door remains immobile, how have we helped the economy? The door symbolizes inflation, and it stays at 1%. But in terms of output, both actions tend to push it higher. More AS from government policy reforms, and a push-back of more AD from the Fed.
A few other random observations:
1. Has this been tried? Yes, in late 1921 the Fed stopped a severe deflation and stabilized the price level. There was then some severe wage cutting and the economy took off like a rocket. And this occurred in a situation where there was very little demand-side fiscal stimulus. Today’s labor markets are nowhere near as flexible, so it would be better to have a bit more monetary stimulus. As we recover, the 99 week UI extension can gradually be scaled back, and this will promote a virtuous circle of more AS and more AD.
2. When the Congress passed a law in 2006 raising minimum wages in three steps, they probably anticipated that NGDP would continue growing at a little over 5% per year. If it had, by now it would be about 10% above current levels. In other words, the minimum wage in 2010 is probably roughly 10% above where Congress would have set in 2006, if they had had perfect foresight about the economy. I know there won’t be any minimum wage cut, but it would almost certainly reduce youth unemployment if it occurred.
3. In the end I still favor a more expansionary monetary policy. The “Bernanke put” will probably keep us out of a permanent Japanese-style zero rate trap, although we can’t even be certain of that. But faster NGDP growth would still lead to faster RGDP growth. Still, the recent language is better than nothing, and may have played a modest role in the recent strength in US equity markets. Later I’ll discuss the risk that the Fed gets lulled into inaction by the “circularity problem.” I’m sick today, and don’t have the energy to do any more posts, but I will say that in 2009 I called for a worldwide orgy of beggar-thy-neighbor policies, so you pretty much know what I think of the recent moves by the Japanese.
4. I know there are some very smart grad students who read this blog, and I would appreciate if you could point me to any research papers that discuss supply-side policies when the central bank is inflation targeting and the SRAS is relatively flat. In the unlikely event there aren’t any, why not write up a paper?
PS: I have a wacky commenter who is a combination of gonzo journalist Hunter S Thompson and Andrew Mellon. Even his name (Morgan) is vaguely reminiscent of the gilded age. This post is dedicated to him.
HT: Tyler Cowen, JimP, Daniel Carpenter