Quick note on the use of “natural rates” in macro analysis

November 24th, 2015 at 9:46 am

In yesterday’s post on underemployment, I employed various concepts used by many in high places in contemporary economic analysis, including “natural rates” of un- and underemployment–i.e., the lowest rates consistent with stable inflation–the “equilibrium” Fed funds rate–the one consistent with stable growth that’s neither too hot nor too cold–and so on.

Some readers and Tweeters were unhappy with such usage, arguing in so many words that a) it is inherently conservative to adopt such constructs as in practice they generate biases against truly full employment and thus against the less advantaged, who benefit most from tight labor markets and are hurt most by slack ones, and b) they’re unobservable and impossible to pin down within a policy-useful margin of error, so why go there?

I acknowledged as much in yesterday’s post: “…there are good reasons not to truck in this whole “natural rate” business at all; there’s no reliable way to nail it down, it moves around, and economists invariably tend to pitch it too high, at great cost to those who depend on truly full employment.”

It’s also important in this corner of economic analysis to be wary of the assumption that there’s an equilibrium state for these variables. That is, even if a rate of unemployment or interest really is consistent with stable prices/growth at time t, that rate may well be out (or moving out) of said equilibrium at time t+1. Check out all the time variation in the “natural rate of interest” from this recent Fed paper (see Figure 5).

And the unobservable problem is huge.

But here’s the thing. When in Rome…That is, there is IMHO a real utility in this work to working within the model that’s in the minds of the key players pulling the key levers. First, if your goal is to nudge the course of the ship a bit, you’ve got to be able to use the same map and navigation system as the captain, even if you don’t wholly believe it.

Second, these people aren’t dopes by a long shot. My beef is more that they’re working in models driven by correlations more than causation and these models have been missing pretty big time for a pretty long time, often at great cost. But prices/wages do, in fact, correlate with slack/capacity utilization, though to different degrees over different times and for different reasons than the classical models often reflect. EG, bargaining power is a critical variable that can get lost in a lot of the macro analysis.

So I will continue to use all the tools and models that everyone else does, but I won’t be limited to them and I will employ them with caution and a dose of skepticism, not cynicism.

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4 comments in reply to "Quick note on the use of “natural rates” in macro analysis"

  1. Kevin Rica says:

    IMNSHO – All these natural rates are a Panglossian rationale for high unemployment, that lasts until events prove them wrong and then they simply claim that the structure of the economy has somehow changed again. But if the structure of the economy is so variable, then there is no natural rate anyway. What was unemployment in 2000? Why is the “natural rate” higher now?

    If we answer that question honestly then the natural rate of unemployment of econometricians will go up. Publish or perish!


    • Ben Groves says:

      What was unemployment in January 1997? I think 2000 unemployment was lower than possible to sustain.

      You need to respect the levels. 5% on the U-3, 6% on the U-4/5 and 9% on the U-6 have been economic boom signals for 20+ years. The holy trinity.


      • Kevin Rica says:

        Ben,

        Why was 2000 unemployment unsustainable? Did you notice 10% inflation?

        What we didn’t sustain was demand. We had recession and then unemployment climbed in 2001. But inflation was always well contained.

        Or is “respect of the levels” simply an exercise in circular logic asserting that the economy would have hit some form of supply-side constraint had the demand side not collapsed?


  2. Smith says:

    The Taylor rule, NAIRU, and the Phillips curve, are ways to justify keeping unemployment at a high enough level to avoid wage pressure. Even in the New York Times, any wage pressure is seen as a warning sign of impending inflation that must be countered (this is in the so-called news reporting, even though it represents opinion).

    There are other ways to deal with inflation. In this post, Krugman pointed to an interesting 1980 paper by Tobin, read page 66 of the paper.
    http://krugman.blogs.nytimes.com/2015/09/01/the-triumph-of-backward-looking-economics/
    http://www.brookings.edu/~/media/Projects/BPEA/1980-1/1980a_bpea_tobin.PDF

    Tobin sounds a defeatist note for reform and even argues for wage controls as if even in the 1970s, the inflation problem wasn’t and always is more about prices, and businesses’ disproportionate control over price vs. labor’s influence on wages, even within labor unions.

    Look at the ACA actually as one model that doesn’t seek to cut labor fees (thanks to the power of the AMA) but attacks inflation in other ways. Even doctors’ salaries are only 8% of healthcare costs, as are autoworkers only 10 to 15% percent of a car’s price.

    Using the bludgeon of higher unemployment to curb inflation is inefficient and counterproductive, literally. Germany allows high wages for industrial workers which then promotes strategies to improve productivity of workers, and quality of products.

    Using the Taylor rule, NAIRU, and the Phillips curve, to create a reserve army of labor is not justified by economics. It is just a convenient way to keep the working man and women in their place, and inequality at record levels. The college educated one third of the labor force enjoy an unemployment rate now of 2.5% so for the ruling class, it matters little, although a significant number still work at jobs not requiring that level of education).

    If you want to control inflation, attack the overwhelming power of business to set prices and increase profits by cutting wages and outsourcing jobs. Create an economy with lower corporate profits, less attempted economies of scale which turn into bloated inefficiency, lower pay for management, more competition. The way to keep inflation under control is to control price increases. Anyone looking at their cable bill could tell you that.


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