In a recent post I praised Steven Williamson for trashing the Phillips curve.  Now Paul Krugman has a post defending the Phillips curve, which I am also going to praise.  How can I agree with such diametrically opposed views?  Simple, Williamson trashes the American version of the Phillips curve, the one using inflation and unemployment.  As you may know I view inflation as an almost worthless concept, which does more to confuse than enlighten.  In contrast Krugman discusses the original version of the Phillips curve.  Well, not the actual original version, that was developed by Irving Fisher in 1923, but Phillip’s 1958 version, which used wage inflation instead of price inflation.  Whereas price inflation is a useless concept, wage inflation is a highly useful concept, especially in business cycle analysis.  Here’s Krugman:

Start with the raw data. Here’s unemployment and increases in nonsupervisory wages since 1985:

What you see is that wage growth was low when unemployment was high, and vice versa. Now take annual averages (to avoid overlapping data) and plot the unemployment rate against the wage change over the next year:

There are a couple of possible explanations for the return of the good old-fashioned Phillips curve: anchored inflation expectations, downward sticky nominal wages. I’ll have more thoughts on that later (actually, downward rigidity and anchored expectations I think reinforce each other). But the point is that notions of how inflation works that were formed in the era of stagflation are very much at odds with the way the world has looked, not just since the Great Recession began, but since the mid-1980s. Yet stagflation still shapes both public perceptions and policy.

Later in the post Krugman criticizes the natural rate hypothesis, which is where he loses me.  I still think that’s a very useful concept, which explains why the US unemployment rate is falling despite stable (2%) wage inflation.  But overall I’m thrilled to see that Krugman prefers the wage version of the PC, he’s far more influential than me.

PS.  Notice that in 2009 wage inflation fell from 4% to 3%, whereas NGDP growth fell by 9 percentage points below trend.  There’s your Great Recession, which had nothing to do with housing/banking/lack of fiscal stimulus etc., etc.  Tight money and sticky wages create recessions.  The Musical Chairs model.

PPS.  Today the BEA raised the estimate of GDP growth once again.  NGDP growth is running 4% in 2013 (NGDI at 3.9%). RGDP at 2.6%.  I can’t wait to do my year end review; it’s been an incredible year for MM, in all sorts of ways.

PPPS.  There is some interesting recent commentary over North Carolina’s reduced UI benefits (here and here).  I’m waiting until we have more data before I chime in.  I’m an agnostic on the issue, and don’t even know if state level results would carry over to the national level.  In 2014 we may get a similar experiment at the national level.

Update:  Kebko’s lastest update on North Carolina is fascinating.

PPPPS.  Off topic, but file this under “It’s good to be the king.”  King Obama has waved what the Supreme Court has ruled is a tax, for lots of Americans.  What a nice Christmas present!

Here is Britmouse:

I find it astonishing that Krugman and Wren-Lewis, having done post after post in 2012 describing how the UK does have real fiscal austerity in 2012, are suddenly happy to now argue that a relaxation of fiscal austerity in 2012 is the “reason” for GDP recovery in… erm, 2013.

Mark Sadowski directed me to one of the most perplexing Paul Krugman posts that I have ever read. Krugman argues that the slow British recovery was caused by a contractionary fiscal policy, which reduced aggregate demand.  Fair enough.  He’s done that before.  Then he presents absolutely no evidence that AD in Britain has done poorly in recent years.  None.  Instead he presents data for RGDP.  OK, he’s done that before, many times.  And I’ve criticized him for doing this, many times.  And he keeps doing it.

But then something really strange happened; he said this:

The only reason Britain isn’t suffering terrifyingly high unemployment is the fact that, for reasons not clear, productivity has collapsed, so that the shrunken economy is still employing a lot of people.

Of course when productivity “collapses” one expects to see RGDP growth “collapse.”  And Krugman has a graph that shows RGDP growth did collapse.  So presumably the collapse in productivity growth at least partly explains the collapse in RGDP growth.  But Krugman simply ignores this clear implication, and writes the rest of the post as if it’s obvious that “austerity” explains the low growth in RGDP, even as employment in Britain does much better than in America, and dramatically better than in eurozone economies that also experienced banking distress, such as Ireland and Spain.

Don’t get me wrong, I believe Britain has had both an AD problem and a productivity problem in recent years, but not due to austerity.  And I believe the AD shortfall partly explains the low RGDP growth.  And that productivity and AD can even interact in the short-run (but that doesn’t even come close to explaining the UK productivity data, as Krugman himself hints at with his “reasons not clear” remark.)  But you’ll never catch me writing a post claiming it’s a demand side problem, where 100% of the evidence actually presented in the post points to it being a supply-side problem.

The truth is that much of the productivity problem in Britain, and hence the RGDP problem, is due to supply-side factors ranging from lower North Sea oil output to fewer gaudy bonuses paid out in the City of London.  None of that has anything to do with “austerity.”

In this comment Mark Sadowski discusses all this in much more depth, and shows that Krugman’s tendency to confuse RGDP with AD also led him to make serious errors in an earlier post comparing this crisis to the Great Depression.

Krugman also ignores the fact that his own graph shows fiscal policy in Britain getting more contractionary in 2013, and yet growth picked up sharply!

Mark Sadowski sent me to this post by John Carney:

Monetary economics is definitely harder to grasp than rocket science, but easier than quantum mechanics. One of the hard parts is breaking free from the notion that interest rate changes are reliable guides to the stance of policy.  And one thing that makes that difficult is that sometimes rate changes they are reliable. When rates rose on rumors of tapering last summer, it was in fact a reliable indicator that policy was expected to tighten, which meant that policy had already tightened by the time you read about it (another concept that is hard to grasp.)

But yesterday monetary policy clearly loosened  (based on the rather obvious stock market rally after the 2:15 announcement), but long rates were almost unchanged.  Yesterday I speculated that the zig zag of 10 year rates reflected the back and forth effects of tapering, forward guidance, and the Fisher/income effects.  The first two shouldn’t even be controversial.  Everyone knows:

1.  A taper announcement by itself pushes up rates.

2.  A taper announcement is the easiest part of the report to quickly ascertain. Traders with their finger on the “sell button” saw “$75 billion” flash on their retina at 2:15 and hit the button. Rates spiked. Stocks fell. That shouldn’t even be controversial.

3.  Then they processed the more complex forward guidance info and rates quickly fell, as you’d expect with forward guidance.

I agree that reading market zig zags is usually a fools game, but I really don’t see how any reasonable person could disagree with this interpretation.  Remember that MMs don’t even have a dog in this fight; we have never claimed that tapering necessarily raises rates, indeed I was initially skeptical until I saw the effect last summer.

But here’s the clincher.  I did all this without having any idea what was going on in the fed funds futures markets.  I wouldn’t even know how to find that data on the internet.  My interpretation implies the rates should have been expected to stay lower for longer, but since 10 year yields finished the day unchanged the subsequent path of rates should have showed a steeper increase (income/Fisher effects).  Today kebko sent me the following comment:

Eurodollar futures started the day with an estimated first rate increase in Nov. 2015 with a slope of 35bp per quarter after that. At the end of the day, the date of the increase had moved back 1 month, and the slope had increased to 37bp per quarter. I think this basically reflects the Fed’s guidance today. They are going to try to keep the rate at zero for longer, which should increase inflationary pressure and lead to faster increases once they do. Rates in the 2-3 year range ended the day down, but rates beyond that ended the day up.

Exactly right.  Several commenters sent me a recent debate where John Taylor argued QE had failed because rates didn’t fall:

JOHN TAYLOR: No, I think — if you think about the purpose of the quantitative easing as stated was to lower long-term interest rates, and if — again, look at QE3. It began just in December of last year, September of last year.

And rates are higher now than they were then. So how you can say it helped? Low interest rates have not been the result.

It would appear Taylor forgot to account for the longer term effects (income and Fisher effects.) Taylor is certainly aware of those effects, but it seems to me that many people tend to overlook their importance in ordinary conversation.

So stocks soared yesterday as ten year yields were unchanged, perhaps because the “unchanged” hid large crosscurrents, which were both expansionary.  Lower yields on the expected future liquidity effect (forward guidance) and then a bounce back on the income and Fisher effects.  Both changes are expansionary.

BTW, Here’s one similarity to quantum mechanics.  A new monetary policy does not take effect until it is observed.  Yes, guidance must be backed up with future actions, but given that Yellen is a dove I see no reason why the markets would have been unusually skeptical about the guidance.  And remember that guidance has important effects even if markets only consider it 40% likely that it will be carried out.  In this case it’s far more than 40%.

Some readers misread my “negative multiplier” comment.  Yesterday was not a negative multiplier example.  It was an example of a market reaction that helps one to better understand how a negative multiplier could occur.  It proves nothing, just an analogy.  Let me explain in a different way.  Suppose I went to the Fed meeting and at the end told the FOMC; “your decision today will drive the Dow up almost 300 points.” I think it’s fair to say they would have been dubious.  They had decided to taper, which normally depresses stocks.  Yes they also slightly adjusted the guidance wording, but I don’t think any reasonable person would disagree with my claim that the rise in stocks was more than the FOMC might have expected for a combined contractionary/expansionary move.

My other claim was that if I am right that they underestimated the effect, it’s because the Fed (like most people) puts more weight on “concrete steppes” than forward guidance.  But they (and most other people) are wrong.  Instead Woodford/Krugman and MMs are right—forward guidance matters more than QE. Where I disagree with Paul Krugman (and perhaps Woodford) is that I believe the likely policy counterfactual in March 2009 if Congress had voted against stimulus was some really serious forward guidance, which would have had an impact that surprised even the Fed.   Maybe even producing a negative multiplier. Yesterday’s market reaction upped my subjective probability of being right about the negative multiplier from about 15% to 25%.  Which means I still think it unlikely, but slightly more plausible than before.

HT:  JTapp, TravisV