Inflation, the Fed, Jobs, and Growth

October 30th, 2013 at 4:42 pm

In a refreshing break from all the health care mishegoss, I keep running into people who want to talk about this idea that faster inflation would help the economy pull out of its growth slog.  Since I view faster growth as an extremely laudable and overlooked goal, allow me to say a bit more about this debate.

Here’s my summary of the critiques I’m picking up:

–faster inflation will just lower real wages and incomes—how could that possibly be a good thing?
–the things that faster inflation does right now won’t help as much as you think they will.
–even if it would help, it’s a lot harder for the Fed to generate faster price growth than people think.

But first, why go there—toward higher inflation—at all?  Two reasons, both having to do with the unfortunate ZLB (zero-lower bound): the fact that the main tool of the Federal Reserve, the Fed funds rate (FFR), is stuck at zero.  First, since the real rate is the nominal rate minus the inflation rate, at the ZLB, the real rate is the rate of inflation times -1.

Second, and this is less important now, a higher inflation rate in general is insurance against running into that ZLB, as explained by Larry Ball here.

Now, this next part is important.  If you use a Taylor rule of thumb to figure out where the FFR should be right now given inflation and unemployment, you get a number around -2%.  With PCE inflation running at 1.2% in the most recent data, that means the effective FFR is still too high.

But if you tweak that calculation is a way that I think you should, i.e., by increasing the measured unemployment rate to reflect its downward bias due to people leaving the labor force because of weak labor demand, then you find that the FFR should be more like -4%.  No wonder we’re stuck in such a slog.  (Later, I’ll post something showing these calculations.)

So, if any of that is close to correct, shouldn’t the Fed be trying to crank up the inflation rate?  Well, let’s consider those bullets above.

I spoke to the first one the other day—I do share concerns about slower real wage growth and I’m not so quick to accept the assumption that faster inflation passes through one-for-one to nominal wages, especially for lower wage workers and especially at times of weak labor demand.  However, I think the pass-through does at least partially occur and that the benefits of faster growth, more jobs, longer average work week, would outweigh the costs.

On the second point, as Mark Zandi noted to me the other day, while higher inflation helps by reducing the debt burden on those who owe nominal dollars to their creditors, it’s a little late for that—the deleveraging cycle is largely behind us.  Zandi also noted, insightfully, I thought, that even if you did lower real labor costs through higher prices, he doubted that would juice much hiring.  Labor costs are already awfully low.

But it’s the third point that I find most interesting and challenging.  There are smart people on opposing sides of this issue of whether the Fed could generate faster inflation, and for reasons both economic and institutional, I think the nay-sayers—the ones who say the Fed could not drive inflation up very much—may be right, though I’d probably change “could” to “would.”

The first thing you want to ask yourself is why haven’t their actions thus far done much in this regard?  The figure below shows a bunch (too many, I know) of lines relevant to this debate.  Ignoring the deficit/GDP ratio for a minute, note that as the FFR went to zero and the balance sheet grew from $1 trillion to $3.5 trillion, inflation (measured by the PCE core deflator) puttered about, and if anything, decelerated most recently as the balance sheet took off.


Sources: Federal Reserve, BEA

There’s always the counterfactual and I wouldn’t for a moment discount the view that we could easily be looking at deflation absent the Fed’s interventions.  But at first blush, it’s certainly not obvious from this picture that the Fed could drive inflation up much (more careful statistical research comes to a similar conclusion re the impact of the Fed’s “unconventional methods” on inflation).

Moreover, there’s a strong, hawkish, institution bias against trying to boost the inflation rate in ways suggested by those calling for significantly faster price growth.  Bernanke and Yellen have proven themselves to be stalwart warriors in the fight against weak job growth and high unemployment.  But they’ve been equally clear that the reason they’re comfortable with aggressive monetary stimulus is that they believe inflationary expectations are “well-anchored.”

Larry Ball sensibly points out that if such expectations are well anchored around 2%, as they are, then there’s no reason they couldn’t be just as well moored at 4%.  But I don’t think Ben and Janet et al buy that argument.  It’s obviously theoretically possible that the Fed could print enough money to gin up more inflation.  But it’s hard to for me to imagine they would.

Finally, there’s the darn Congress.  I have argued long and hard that even aggressive monetary policy is rendered far less effective when faced with fiscal headwinds, as you see in the chart (note the rise in the deficit to GDP ratio; that’s fiscal drag).  I’m sure Bernanke agrees, which is why he used to always be importuning the Congress to help him out with some fiscal tailwinds for which they rewarded him with the opposite.

The point is that this too makes it hard for the Fed to generate more inflation, or for that matter, much more growth.  They can set the table with lower rates at both the short and long end of the yield curve, and they’ve done so.  But absent more good, old-fashioned demand from households and companies, there’s too few customers sitting down at that table to buy a meal.

All of which leads me to the conclusion of this fascinating (; > {)) discourse: our economy is seriously demand-constrained and while the Fed is doing a lot to help, we’re still stuck slogging along (e.g., look at the recent deceleration in the ADP jobs numbers).

Much more needs to be done.  Maybe this new budget conference will loosen the knot of sequestration a bit, but that’s not what I’m talking about.  I actually have what I humbly submit is a strong, pro-job-growth agenda in mind, which I’ll be rolling it out shortly, so stay tuned.  And no, it won’t get anywhere soon (even though it’s surprisingly inexpensive), but I’m playing the long game here.  It’s the only one in town.

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7 comments in reply to "Inflation, the Fed, Jobs, and Growth"

  1. Fred Brack says:

    Thanks, Jared, for keeping your eye on the ball. It’s remarkable that, for the past three years, to be characterized as “serious” a discussion has to be about debt and deficits — which, of course, are “spinning out of control.” Meanwhile, the five-plus year-old mass unemployment crisis crushing the middle and working classes has become ho-hum, tell me something new. The clubby, well-upholstered, well-tailored Fix the Debt class are like a lawn-care salesman hectoring a homeowner about his “serious” crab-grass problem while his house burns down and the salesman’s pickup blocks firetrucks’ access to the inferno.

  2. Lance Brofman says:

    “…The effects of the 2007 depression are much less severe than the 1929-41 depression because of safety-net benefits now provided. Consider the horrendous, though not uncommon situation of a household in 1932 comprised of elderly grandparents being supported by their working-age children with young children of their own, when the breadwinners became unemployed. The 1932 family would be destitute. Today the grandparents would have social security and Medicare benefits. Their working-age children could now collect unemployment benefits for up to 99 weeks. Additionally, the entire family could also be eligible for food stamps, Medicaid, rent subsidies, heating fuel subsidies, free school lunches and other benefits. The 1932 family might also have had a bank account in one of the many banks that failed and lost their savings. Today, Federal Deposit Insurance protects such bank accounts. You might say we are now in a depression with benefits.

    The difference between a depression and a severe recession are not just semantic. Recessions occur when the Federal Reserve raises interest rates in an effort to slow down an overheated economy. Most importantly, recessions end when the Fed lowers interest rates. In a recession the pent-up demand for housing and durable goods means that monetary policy alone can cure the recession. Just as antibiotics can be effective against bacterial infections but not against viruses, monetary policy alone cannot end a depression. Furthermore, modest fiscal stimulus and the automatic stabilizers that can hasten the end of recessions cannot end a depression. There can be ups and downs in the unemployment rate during a depression. However, the unemployment rate remains elevated. It was 14.5% in 1940 and 9.7% in 1941.

    If we are in a recession, economic activity will fully resume just from the monetary and fiscal stimulus that has already occurred. Ultimately interest rates will rise. However, if we are in a depression, even one with safety-net benefits that mitigate the hardships, interest rates will remain relatively low for decades as was the case in Japan and the USA of the 1930s, where only World War II ended the depression. The ideal investment for an extended period of low interest rates is agency mREITs.

    Depressions occur after investment bubbles burst. In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.

    The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 – First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments.

    If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990s when tax rates on the rich just happened to be high enough to prevent overinvestment, the economy has generally suffered from periodic overinvestment cycles.
    It is not just a coincidence that tax cuts for the rich have preceded both the 1929 and 2007 depressions. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increased savings and investment. However, overinvestment (by 1929 there were over 600 automobile manufacturing companies in the USA) caused the depression that made the rich, and most everyone else, ultimately much poorer.

    Since 1969 there has been a tremendous shift in the tax burdens away from the rich and onto the middle class. Corporate income tax receipts, whose incidence falls entirely on the owners of corporations, were 4% of GDP then and are now less than 1%. During that same period, payroll tax rates as percent of GDP have increased dramatically. The overinvestment problem caused by the reduction in taxes on the wealthy is exacerbated by the increased tax burden on the middle class. While overinvestment creates more factories, housing and shopping centers; higher payroll taxes reduces the purchasing power of middle-class consumers…”

  3. Tom in MN says:

    Let’s just hope the long term is only until after the midterm elections.

  4. Tyler Healey says:

    Jared, why doesn’t the president propose a tax cut for the middle class and the poor? I thought he believed in bottom-up/middle-out economics?

    Is he not aware of how awful the economy is? The Labor Force Participation Rate was 66% when he entered office and is now 63%.

  5. smith says:

    A pro growth job agenda which relies on government largess (wage subsidies) is perhaps a noble but misguided effort to break the logjam preventing progress in restoring full employment. It is corporate welfare, a way for business to hire new workers without paying fair wages (different from Germany’s temporary subsidies to prevent layoffs). It unfairly hurts any business that plays by the rules, pays a decent wage, and doesn’t seek to game the system. Studies showing wage subsidies work and create new hiring are flawed and subject to interpretation. The whole concept is akin to tax breaks that states favor on businesses to entice them to relocate or open new facilities in their area. Those tax breaks create winners and losers and on balance, don’t help the overall economy.
    Even beneficial programs that assist chronically unemployed, which merit support and serve an important purpose of breaking a hopeless cycle, hurt in the near term the otherwise more employable job seeker. But subsidies on a scale intended to address millions of underemployed would depress everyone’s wage, subject to downwardly nominal wage rigidities of course.
    A better idea is for progressives to step up and win back the house based on effective ideas to restore economic balance. Break up the banks, the monopolies, regulate and tax big pharma, big oil, raise corporate taxes, pass the financial transaction tax, and close loopholes like carried interest and foreign revenues, stop all foreclosures (we’re not deleveraged), raise the minimum wage, increase spending on infrastructure, renewable energy research, pollution control, free college for all (like high school), enforce labor law by ending exempt status, pass 35 hour work week, or 4 day work week, 5 weeks vacation, repeal Taft-Hartley, allow immigration without employer controls/sponsorship, rehire teachers, police, and firemen, strengthen labor and redirect investment instead weakening them with more corporate welfare.

    • smith says:

      I left out a very important measure of reform which was restoring state usury laws lost in 1978 court decision on national banks, and repealing 2005 bankruptcy bill. The less wealthy one is, the more these laws punish and tax. 30% interest rates and the ending of fresh start bankruptcy removes the moral hazard banks used to face, and encourage bubbles and reckless lending.

  6. bakho says:

    The type of inflation we need is WAGE inflation. We could get some meaningful wage inflation by raising the minimum wages. That would help with balance sheets, help the SSTF reduce EITC and leave more money for fiscal job creation.

    Some prices are sticky and those prices need wage inflation to reset the relative price levels. Economic management since 2000 has promoted cheap labor which is how we got into this mess.

    -jonny bakho