Confused about why the Fed is committed to higher inflation despite mixed signs of recovery in the US economy? Good. Edward Price, a former British economic official and current teacher of political economy at New York University’s Center for Global Affairs, explains the paradox at the heart of the US central bank’s new monetary framework.
Erwin Schrödinger, a physicist, studied the tiniest of things. And he discovered something bizarre. If observed, the atomic world will change its state. Schrödinger illustrated this idea with an imagined cat. In an irradiated box, and as long as this cat remains unseen, it can remain both dead and alive. Only when the box is opened will its actual fate occur.
Which is ludicrous. Schrödinger himself admitted as much. He hoped his thought experiment would illustrate the absurdity of other quantum scientists’ views. But, as a theory, it’s no more or less ridiculous than some mainstream economics.
That includes ideas that lie at the heart of monetary policymakers’ models.
Take the Phillips curve. It posits an inverse relationship between inflation and unemployment. Simply put, the more people with jobs, the more money there is in the system. That, in turn, should mean a higher rate of inflation. For many years, the Phillips curve was considered economic science. But then, in the late 1960s, Milton Friedman treated the curve to a savage takedown. He showed policymakers can’t rely on the trade-off between wages and prices — injecting inflation to lower unemployment — because workers will notice what they’re up to and demand better pay as a result. Eventually, he argued, inflation will outpace job gains, something which occurred in the 1970s. Moreover, the Phillips curve doesn’t explain situations when both inflation and unemployment are low, for example during the first quarter of 2020.
Yet, none of these flaws, it seems, has truly knocked the inflation-employment trade off from its golden pedestal. The theory is still referenced today, especially by central banks. Today, for instance, markets’ attention has been focused on the non-farm payrolls figures. These figures were dreadful, with the US economy only adding about a quarter of expected job gains.
Given concerns over the US economy’s ability to recover, Jay Powell, the Fed chair, has made clear that the Fed will provide support for “as long as it takes” to achieve a buoyant job market and, with it, inflation. At first glance, there’s nothing wrong with that. Under the Fed’s contract with the government, it must produce two things: stable prices and full employment. But, at a second glance, that mandate appears at odds with Friedman’s description of the Phillips curve. Full employment is supposed to forfeit stable prices and vice versa.
To get round this, the Fed has concocted two conceptual hacks.
The first is the non-accelerating inflation rate of unemployment, or NAIRU. A mouthful, NAIRU simply refers to the idea that, in any stable monetary system, some people naturally won’t have jobs. In turn, there’s no need to pursue literal full employment.
The other leeway comes from an equally playful definition of stable prices. The Fed, and other central banks, can’t pursue nominal price stability. That would require an entirely static monetary system in equilibrium with an entirely static economic system. Which is impossible. Instead, a gentle reminder to go out and spend — the loss of real purchasing power, which comes about with a little inflation — is preferred.
That loss of real purchasing power has largely eluded central banks of late, however. That’s despite U3, the most commonly used measure of unemployment, falling to levels consistent with NAIRU.
Which explains why the Fed last year abandoned its old framework and adopted a flexible average inflation target (FAIT), under which it can tolerate inflation above its goal of 2 per cent for (an unspecified) period. The aim is twofold, and simple. More inflation and, with that, more jobs. In other words, if inflation is so persistently low, the notion of NAIRU has got to go.
This is where things get weird.
The proposed mechanics of FAIT are an affirmation of Phillips curve theology. In other words, FAIT assumes the curve is alive and well. More inflation will result in more jobs. But, at the same time, it’s only possible to adopt FAIT because the Phillips curve is very much dead. And monetary policymakers killed it. Without the persistently low inflation monetary authorities have achieved, no central banker would dare embark on a bout of deliberate and sustained inflation.
So, which is it? Is the Phillips curve alive or dead?
On the one hand, alive. In combination with actual and proposed US fiscal stimulus, which amasses to almost a quarter of US GDP, the central bank might have a pretty good shot at producing an upward tick in prices. On the other hand, dead. Today’s nonfarm numbers were woeful. If the conclusion is we’ve been measuring unemployment wrong this whole time, and for whatever reason inflation remains low, we can indeed kiss goodbye to NAIRU.
This is the conundrum at hand. The Fed’s stance only makes sense because the natural rate of unemployment is at once known and unknown.
Economists have long been accused of physics envy, or the desire to predict the macroeconomy as reliably as physicists predict natural phenomena. But the most compelling parts of both physics and economics have nothing to do with Newtonian mechanics. Instead, people are like atoms. Interact with them, and things invariably get strange. The macro cannot be extrapolated from the microscopic, at least not until after the event. For mainstream equilibrium theory, this is a bitter red pill. But it seems the Fed has swallowed it, waking up from the slumber of dismal science to a far stranger reality.
Welcome to the weird and wonderful world of quantum central banks.
Related linksA farewell to forward guidance at the Fed — FT Alphaville