In economic policy, new findings can sometimes break through the noise based on their timing, relevance, and importantly, who finds the findings. For example, when the President’s Council of Economic Advisors (CEA) publishes highly relevant results on a very hot topic in the annual Economic Report of the President (ERP), it matters.
This year’s ERP, out today, has a series of figures in it that may well become important. At least, I hope so, because the CEA is presenting vital information about the evolving constraints on our ability to track a relationship at the core of macroeconomics: that between unemployment and inflation. And that, in turn, suggests the natural rate of unemployment is both lower than commonly thought and a lot harder to accurately pin down.
Why is it so important? The “Phillips curve” represents the negative correlation between inflation and unemployment, and the Fed works off of this correlation to calibrate monetary policy designed to balance the competing goals of full employment and stable inflation. The larger the negative correlation, the greater the competition. If a mere tick down in unemployment led to a sharp tick up in price growth, the Fed would have to strike quickly and firmly by raising interest rates to stop unemployment from falling and prices from spiraling upwards.
Instead, these three figures from the new ERP, out this morning, tell the opposite story, showing a much diminished correlation over time.
The first figure shows the strength of the correlation between unemployment and prices over time (technically, it plots a statistic called “R-squared,” the percent of the variance in price changes explained by the unemployment rate over subsequent 20-year time periods). Peak correlation occurred in the early 1990s, but the relationship has weakened since then, and the end of the figure shows that unemployment explains almost none of the variation in inflation in recent years.
The next figure shows what this means in terms of the responsiveness, or “elasticity,” of price changes to the unemployment rate. Over the full period, the elasticity was significant: a one point increase in unemployment led inflation to fall by -0.4 percentage point. But, as you see, the elasticity is far from constant, and by the end of the period, it too is just about zero.
Economists have long used the equation you see in those graphs to back out the so-called NAIRU—the non-accelerating inflation rate of unemployment—or the lowest unemployment rate consistent with stable prices. You can see where knowing this lower limit to the jobless rate would be extremely important information to the Fed.
But the CEAs findings (see last figure below) corroborate what some of us have long maintained: the natural rate a) has been falling for a while, and b) is hard to pin down to a reliable point estimate. For those of us who were always suspicious that a “natural rate” could be identified accurately enough to guide policy, the mid-1990s were highly instructive. Back then, as you see in the chart, economists thought the lowest you could go on unemployment was 6 percent. But Fed chair Alan Greenspan recognized other moving parts in the economy, most importantly faster productivity growth, that meant unemployment call fall below the supposed natural rate without juicing inflation. He was right: unemployment was 4 percent in 2000, and inflation was pretty well-behaved.
And, of course, if you’re following this in real time today, you know that despite the fact that unemployment is down to what the Fed thinks is full employment (4.9 percent), inflation has been so low that the Fed’s long been missing their 2 percent target. Which, by the way, is perfectly consistent with the CEA charts above showing such a flat Phillips curve.
What you’re left with is a point estimate for the natural rate of around 4.5 percent surrounded by a 50-percent confidence band that in 2014 ranges from –4.3 to 6.1 (the figure shows the confidence band to stop at zero because even full-employment freak like me isn’t pulling for negative rates of unemployment). In other words, we cannot, with confidence estimate a natural rate right now.
Does all this mean the relationship between slack and inflation is dead forever? That the Fed can stop worrying? Certainly “no” on the first point. These lines move around and someday they may revert to earlier patterns. I guarantee you that if the job market keeps tightening, workers will have more bargaining power and that will lead to faster wage, if not price, growth. We may already be seeing some of that. I also worry that today’s low productivity growth, the opposite of what Greenspan faced, poses a constraint on these dynamics.
But these figures should lead to a major rethink by those, including some Fed governors, who think transient factors like cheap oil and the strong dollar are temporarily jamming the signal from the Phillips curve to the natural rate. The findings at the end of each series above are based on the last 20 years of data. None of us know the future, but when models fail like this, we must look under new rocks.
Most importantly, the Fed must be, as Chair Yellen often stresses, data driven, not model driven. They can’t know the natural rate with any confidence right now. They must know the weakness of the slack/inflation correlation. Add to those facts how critical it is for working people that we get to and stay full employment, and the bar to pre-emptive rate hikes should be extremely high.
The CEA, much like the CBO across town, does not congenitally go out on limbs. The fact that they’re publishing this work suggests it’s closer to the mainstream than when Dean Baker and I were making noises about this back in the Greenspan years. That is a real advance in economics and anyone drawing a paycheck should thank these wonks and their staffs for their honest and hopefully highly-influential work.