Deflation, inflation, oil prices and asymmetries

When both headline and core inflation rose above target after the financial crisis, helped by rising oil prices, the Fed and Bank of England kept their nerve and did not raise interest rates. They saw through what was a temporary episode. The ECB’s judgement was not as good. Even in the UK it was close, with three out of nine MPC members voting for a rate increase for a few months. But it was the outcome that mattered - excess inflation was ignored because it was temporary. To what extent is what we are seeing right now just the mirror image of this period?

In terms of where inflation is and the monetary policy response, the situation today does indeed look like a mirror image. Headline inflation is or is about to be negative, and core inflation has fallen below target. As Tim Duy points out for the US, core inflation seems to be heading lower rather than returning to target. However I think that is where the symmetry ends. While the dangers of letting inflation rise above target because of temporary shocks are small, the dangers in the opposite direction are more serious. 

One of the arguments used by the inflation hawks when oil prices were high is that even if the impact of higher oil prices on inflation was itself temporary, there was a danger that inflation expectations would increase, and the central bank would lose its anti-inflation credibility. My response at the time was three-fold: first, the private sector can see the reason that rates are not being raised (the continuing recession), so credibility should not be in danger; second, the best indication that the expectations that matter have shifted is when nominal wage inflation starts to pick up (which it did not), and third when that happens it will be easy to restore credibility and reduce expectations by raising rates. [1]

None of these arguments apply with deflation today. Then unemployment was clearly too high. Today unemployment is not clearly too low. How far we are from the natural rate is unclear, but no one would argue that we are in a boom that is the mirror image of the recession a few years ago. The second argument is that we could use changes in nominal wages as a clear indicator that the inflation expectations that mattered had shifted. That argument is not symmetrical because of the well known resistance to nominal wage cuts. Finally if credibility does seem about to be lost, the central bank will find it very difficult to take action to restore it because of the Zero Lower Bound (ZLB).

Please allow me to get technical for just one paragraph, which can be safely skipped. As has often been pointed out, the ZLB means that there are two steady states in the economy associated with a given real interest rate: the ‘intended’ equilibrium with target inflation, and the ‘ZLB equilibrium’ when inflation is negative. I recently discussed a paper that treated agents views about which equilibrium was appropriate as a ‘belief’ and that perhaps the liquidity trap could be a manifestation that agents believed we were heading for the ZLB steady state. The controversial aspect of this analysis is the suggestion that this belief could be shifted by the monetary authorities raising rates. I find that very unconvincing, but it would be a mistake to dismiss the exercise completely on that account. In that post I did suggest an alternative rationalisation for why we might be heading for the ZLB equilibrium: agents no longer believed that the monetary authority had the means to stop it happening.

This last asymmetry is the one that troubles me the most, and why I am not as relaxed as monetary policy makers appear to be about deflation. There are three interpretations of this relaxed attitude to negative headline inflation. The first is the one I suspect monetary policy makers actually hold, which is that the beneficial impact of lower prices on demand will with a year or so push inflation back to target, so there is no reason for concern. [2] I think the probability is that they are correct, but good policy does not just think about the most likely outcome, but should also be robust to risks, particularly risks with large consequences.

The second interpretation that the private sector could give for the relaxed attitude by central banks in the US and UK is that deviations above and below 2% are not treated symmetrically. In theory this should be more of a concern in the US than the UK, because in the UK asymmetry is against the central bank’s mandate. However I’m not sure the private sector thinks that is as important as MPC members do. There is one obvious additional asymmetry between now and a few years ago: many of those calling for higher rates back then are still pushing for higher rates today.

The third interpretation about why central banks are doing nothing is there is nothing they can do. Quantitative Easing seems to have come to a permanent halt either because it has stopped having a useful effect, or because policy makers fear it is having undesirable consequences. Under this interpretation the inflation target loses credibility not because the private sector no longer believes policy makers’ stated objectives, but because they no longer believe they have the means to achieve them. 

This possibility is the one that should really be worrying central banks right now. It is a scenario that is quite consistent with what is currently happening, and it puts at risk central bank credibility in a most fundamental way. Quite simply, central bank credibility is destroyed because people believe they have lost the ability (rather than the will) to do their job, and there is very little central banks can do to get it back because of the ZLB. This is what should be giving central banks nightmares. Strangely, however, they seem to be sleeping just fine.

[1] A footnote for macroeconomists: this is why I have never been convinced by Cochrane’s worries about using the inflation target as a transversality condition.

[2] Resistance to nominal wage cuts may also dampen any the deflationary path, giving time for these positive effects to come through. However resistance to nominal wage cuts does not mean the ZLB equilibrium will never occur – in the paper I discuss in this post, it is the reason why that equilibrium is associated with high unemployment.

  

Asymmetries and Uncertainties

This post starts off talking about the UK, but goes on to make more general points about why we may have wasted resources on a huge scale over the last five years, and why this waste may be continuing.

I presented my new National Institute Economic Review paper on the macroeconomic record of the UK Coalition government yesterday, and reaction mainly focused on my conservative estimates of the cost of the move to austerity in 2010 and 2011: a cumulated loss of 5% of GDP or £1500 for each adult and child. The basis for those figures is outlined here, and their conservative nature comes from taking OBR estimates for the impact of fiscal contraction, and assuming (rather improbably) that the output lost through austerity was entirely recovered by 2013.

The key issue with numbers of this kind involves monetary policy. Some argue that without austerity monetary policy would have been more contractionary: the ‘offset’ argument. Of course some of the large increase in UK inflation in 2011 was the direct result of austerity: the VAT increase is the obvious example. In addition, the inflation of 2011 was not foreseen in 2010, so it does not alter the fact that austerity was a policy mistake, but just influences any calculation of the size of the mistake.

The paper addresses the offset argument. I use Bank of England forecasts to suggest that monetary policy was not able to hit its target for forecast inflation for much of this period, implying that the Zero Lower Bound (ZLB) constraint was biting. If the ZLB constraint bites, there will be no offset. Not surprisingly, when that target for expected inflation was not met, the Quantitative Easing programme was expanded. There was only a brief period in 2011 when this was not true, which was the period in which 3 out of 9 MPC members voted to increase rates. So if we had not had 2010 austerity, then at most interest rates might have begun rising in 2011, which given lags might have reduced GDP to some extent that year. But crucially the OBR numbers that I use already embody some monetary offset, because they are based on empirical estimates of average multipliers over the past. To use these OBR numbers and then do some monetary offset involves double counting.

However, I want to stay with my ‘no austerity’ counterfactual to make a more fundamental point. If interest rates had been raised in 2011, and this had reduced GDP in 2011 and 2012, we would now be talking about the MPC’s 2011 mistake, rather than the government’s 2010 mistake. I would be calculating how much GDP had been wasted in 2011 and 2012 as a result of premature monetary tightening. I would be right to do so, because the costs of delaying a recovery from a deep recession dwarf any benefits from reducing inflation a bit following a commodity price shock.

This indicates a fundamental problem, which policymakers have still not taken on board. For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock. Policymakers are continuing to make this mistake today: core inflation is not too far away from target, and growth is quite healthy, so it is OK to do nothing (or in the Eurozone, it is OK to wait for ages before doing anything). However it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target, so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.

One way to put this point is to go back to the basic rationalisation behind flexible inflation targeting. It is OK to have a target based on inflation alone, with no mention of the output gap, because you cannot in the long run keep inflation at target without also keeping the output gap at zero. This is sometimes called the divine coincidence. However if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.

Are DSGE models distorting policy? - a test case

The debate about the current state of academic macroeconomics continues, but it has reached a kind of equilibrium. Heterodox economists, some microeconomists and many others are actively hostile to the currently dominant macro methodology. Regardless, academic macroeconomists in the papers they write carry on using, almost exclusively, microfounded DSGE models. [1] Critics say this methodology was crucial in missing the financial crisis, but academic macroeconomists respond by highlighting all the work currently being done on financial frictions. I personally think missing the crisis was down to failings of a different kind, but that DSGE did hold back our ability to understand the impact of the crisis. However what I want to suggest here is a forward looking test.

Many of the difficult choices in conducting monetary (and sometimes fiscal) policy involve trade-offs between inflation and unemployment. We saw this in the UK particularly after the crisis, with inflation going well above target during the depth of the recession. What you do in those circumstances depends critically on the costs of excess inflation compared to the costs of higher unemployment. Is 1% higher unemployment worth more or less than 1% higher inflation to society as a whole?

What do New Keynesian DSGE models say about this trade-off? They do not normally model unemployment, but they do model the output gap, which we can relate to unemployment. Their answer is that inflation is much the more important variable, by a factor of ten or more. One reason they do this is that they implicitly assume the unemployed enjoy all the extra leisure time at their disposal. I have discussed other reasons here.

Empirical evidence, and frankly common sense, suggests this is the wrong answer. Thanks to the emergence of a literature that looks at empirical measures of wellbeing, we now have clear evidence that unemployment matters more than inflation. Sometimes, as in this study by Blanchflower et al, it matters much more. Another recent study by economists at the CEP shows that “life satisfaction of individuals is between two and eight times more sensitive to periods when the economy is shrinking than at times of growth”, which as well as being related to the unemployment/inflation trade-off raises additional issues around asymmetry.

So the DSGE models appear to be dead wrong. Furthermore the reasons why they are wrong are not deeply mysterious, and certainly not mysterious enough to make us question the evidence. For example prolonged spells of unemployment have well documented scarring effects (in part because employers cannot tell if unemployment was the result of bad luck or bad performance), which may even affect the children of the unemployed. So it is not as if economists cannot understand the empirical evidence.

Does that mean that the DSGE models are deeply flawed? No, it means they are much too simple. Does that mean that the work behind them (deriving social welfare functions from individual utility) is a waste of time? I would again say no. I have done a little work of this kind, and I understood some things much better by doing so. Will these models ever get close to the data? I do not know, but I think we will learn more interesting and useful things in the attempt. The microfoundations methodology is, in my view, a progressive research strategy.

So academics are right to carry on working with these models. But many academic macroeconomists go further than this. They argue that only microfounded DSGE models can provide a sound basis for policy advice. If you press them they will say that maybe it is OK for policymakers to use more ‘ad hoc’ models, but there is no place for these in the academic journals. In my view this is absolutely wrong for at least two reasons.

First, models that are clearly still at the early development stage should not be used to guide policy when we can clearly do better. In this particular case we can easily do better just by using ad hoc social welfare functions on top of an existing DSGE model. (The Lucas critique does not apply, which is why I like this example.) Yes these hybrid models will be ‘internally inconsistent’, but they are clearly better! Second, to confine academics to just doing development work on prototype experimental models is stupid: academic economists can have many useful things to say starting with aggregate models (as here, for example), and this is not something that policymakers alone have the resources (or sometimes the inclination) to do. (We also know that academics will give policy advice, whatever models they use!) Analysis using these more ad hoc but realistic models should be scrutinised in high quality academic journals.

Let’s be even more concrete. Take the debate over whether we should have a higher (than 2%) inflation target (or some other kind of target), because of the risks of hitting the zero lower bound. If this debate just involves micofounded DSGE models which clearly overweight inflation relative to unemployment, then these models will be guilty of distorting policy. This is not a matter of running some variants away from microfounded parameters (as in this comprehensive analysis, for example), but adopting realistic parameters as the base case. If this is not done, then microfounded DSGE models will be guilty of distorting this policy discussion.

[1] A few elderly bloggers, who use both DSGE and more ‘ad hoc’ models and think the critics have a point, are regarded by at least some academics as simply past their sell-by date.

Inflation risks

When it comes to the issue of when interest rates should start rising, one of the points I and others have often made is that the risks are not symmetric. If inflation starts rising faster than we expect monetary policy can quickly respond. Alternatively if we actually have more ‘spare capacity’ than we currently believe, it may take some time for this to become apparent (inflation is more sticky when it gets low), and the zero lower bound limits what monetary policy can do.

In this light, the following table from the Bank of England’s inflation report issued today is rather interesting. 

In scenario 1, there is more slack in the labour market than the Bank currently thinks. In scenario 2, firms are currently working at a higher rate of capacity utilisation than the Bank estimates. In both scenarios monetary policy is endogenous. Inflation is higher in scenario 2, but monetary policy succeeds in getting it back to target by the middle of 2017. In scenario 1, inflation remains below target throughout the period.

Now as a macroeconomist I really want to know more. These are different shocks, so they are not a pure test of asymmetry. The path of interest rates is not shown, so we do not know how much of a constraint the zero lower bound is (if at all) in scenario 1. In scenario 1 unemployment falls quite a lot more than in the central projection, but the additional GDP growth seems small by comparison. The opposite is true in scenario 2. This is undoubtedly a result of different shocks being applied, but all the report tells us is that judgement was used in deciding how to shock the model to best capture each scenario. As I am sure Tony Yates would say, it would be nice for those who are interested in this detail to know a bit more.

However, putting all these qualifications aside, these simulations are welcome given all the discussion underway. They suggest that the upside risks to inflation are small, because monetary policy is capable of responding quickly. Overestimating the degree of current slack does not lead to inflation ‘taking off’. Perhaps this helps to explain why the Bank appears to some to be rather relaxed about the need to raise rates.     

New Keynesian models and the labour market

Do all those using New Keynesian models have to believe everything in those models? To answer this question, you have to know the history of macroeconomic thought. I think the answer is also relevant to another frequently asked question, which is what the difference is between a ‘New Keynesian’ and an ‘Old Keynesian’?

You cannot understand macro today without going back to the New Classical revolution of the 1970s/80s. I often say that the war between traditional macro (Keynesian or Monetarist) and New Classical macro was won and lost on the battlefield of rational expectations. This was not just because rational expectations was such an innovative and refreshing idea, but also because the main weapon in the traditionalists armoury was so vulnerable to it. Take Friedman’s version of the Phillips curve, and replace adaptive expectations by rational expectations, and the traditional mainstream Keynesian story just fell apart. It really was no contest. (See Roger Farmer here, for example.)

I believe that revolution, and the microfoundations programme that lay behind it, brought huge improvements to macro. But it also led to a near death experience for Keynesian economics. I think it is fairly clear that this was one of the objectives of the revolution, and the winners of wars get to rewrite the rules. So getting Keynesian ideas back into macro was a slow process of attrition. The New Classical view was not overthrown but amended. New Keynesian models were RBC models plus sticky prices (and occasionally sticky wages), where stickiness was now microfounded (sort of). Yet from the New Classical point of view, New Keynesian analysis was not a fundamental threat to the revolution. It built upon their analysis, and could be easily dismissed with an assertion about price flexibility. Specifically NK models retained the labour leisure choice, which was at the heart of RBC analysis. Monetary policymakers were doing the Keynesian thing anyway, so little was being conceded in terms of policy. [1]

So labour supply choice and labour market clearing became part of the core New Keynesian model. Is this because all those who use New Keynesian models believe it is a good approximation to what happens in business cycles? I doubt it very much. However for many purposes allowing perfect labour markets does not matter too much. Sticky prices give you a distortion that monetary policy can attempt to negate by stabilising the business cycle. The position you are trying to stabilise towards is the outcome of an RBC model (natural levels), but in many cases that involves the same sort of stabilisation that would be familiar to more traditional Keynesians.

This is not to suggest that New Keynesians are closet traditionalists. Speaking for myself, I am much happier using rational expectations than anything adaptive, and I find it very difficult to think about consumption decisions without starting with an intertemporally optimising consumer. I also think Old Keynesians could be very confused about the relationship between aggregate supply and demand, whereas I find the New Keynesian approach both coherent and intuitive. However, the idea that labour markets clear in a recession is another matter. It is so obviously wrong (again, see Roger Farmer). So why did New Keynesian analysis not quickly abandon the labour market clearing assumption?

Part of the answer is the standard one: it is a useful simplifying assumption which does not give us misleading answers for some questions. However the reason for my initial excursion into macro history is because I think there was, and still is, another answer. If you want to stay within the mainstream, the less you raise the hackles of those who won the great macro war, the more chance you have of getting your paper published.

There are of course a number of standard ways of complicating the labour market in the baseline New Keynesian model. We can make the labour market imperfectly competitive, which allows involuntary unemployment to exist. We can assume wages are sticky, of course. We can add matching. But I would argue that none of these on its own gets close to realistically modelling unemployment in business cycles. In a recession, I doubt very much if unemployment would disappear if the unemployed spent an infinite amount of time searching. (I have always seen programmes designed to give job search assistance to the unemployed as trying to reduce the scaring effects of long term unemployment, rather than as a way of reducing aggregate unemployment in a recession.) To capture unemployment in the business cycle, we need rationing, as Pascal Michaillat argues here (AER article here). This is not an alternative to these other imperfections: to ‘support’ rationing we need some real wage rigidity, and Michaillat’s model incorporates matching. [2]

I think a rationing model of this type is what many ‘Old Keynesians’ had in mind when thinking about unemployment during a business cycle. If this is true, then in this particular sense I am much more of an Old Keynesian than a New Keynesian. The interesting question then becomes when this matters. When does a rationed labour market make a significant difference? I have two suggestions, one tentative and one less so. I am sure there are others.

The tentative suggestion concerns asymmetries. In the baseline NK model, booms are just the opposite of downturns - there is no fundamental asymmetry. Yet traditional measurement of business cycles, with talk of ‘productive potential’ and ‘capacity’, are implicitly based on a rather different conception of the cycle. A recent paper (Vox) by Antonio Fatás and Ilian Mihov takes a similar approach. (See also Paul Krugman here.) Now there is in fact an asymmetry implicit in the NK model: although imperfect competition means that firms may find it profitable to raise production and keep prices unchanged following ‘small’ increases in demand, at some point additional production is likely to become unprofitable. There is no equivalent point with falling demand. However that potential asymmetry is normally ignored. I suspect that a model of unemployment based on rationing will produce asymmetries which cannot be ignored.

The other area where modelling unemployment matters concerns welfare. As I have noted before, Woodford type derivations of social welfare give a low weight to the output gap relative to inflation. This is because the costs of working a bit less than the efficient level are small: what we lose in output we almost gain back in additional leisure. If we have unemployment because of rationing, those costs will rise just because of convexity. [3]

However I think there is a more subtle reason why models that treat cyclical unemployment as rationing should be more prevalent. It will allow New Keynesian economists to say that this is what they would ideally model, even when for reasons of tractability they can get away with simpler models where the labour market clears. Once you recognise that periods of rationing in the labour market are fairly common because economic downturns are common, and that to be on the wrong end of that rationing is very costly, you can see more clearly why the labour contract between a worker and a firm itself involves important asymmetries - asymmetries that firms would be tempted to exploit during a recession. 

Yet you have to ask, if I am right that this way of modelling unemployment is both more realistic and implicit in quite traditional ways of thinking, why is it so rare in the literature? Are we still in a situation where departures from the RBC paradigm have to be limited and non-threatening to the victors of the New Classical revolution?

[1] When, in a liquidity trap, macroeconomists started using these very same models to show that fiscal policy might be effective as a replacement for monetary policy, the response was very different. Countercyclical fiscal policy was something that New Classical economists had thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g. Shimer, 2010) that hours per worker are quite acyclical, has been used in RBC models: early examples include Hansen (1985) and Hansen and Wright (1992). Michaillat also assumes constant labour force participation, so the labour supply curve is vertical, and critically some real wage rigidity and diminishing returns.

(b) Consider a deterioration in technology. With flexible wages, we would get no rationing, because real wages would fall until all labour was employed. What if real wages were fixed? If we have constant returns to labour, then if anyone is employed, everyone would be employed, because hiring more workers is always profitable (mpl>w always). What Michaillat does is to allow diminishing returns (and a degree of wage flexibility): some workers will be employed, but after a point hiring becomes unprofitable, so rationing can occur.  

(c) Michaillat adds matching frictions to the model, so as productivity improves, rationing unemployment declines but frictional unemployment increases (as matches become more difficult). Michaillat’s model is not New Keynesian, as there is no price rigidity, but there is no reason why price rigidity could not be added. Blanchard and Gali (2010) is a NK model with matching frictions, but constant returns rules out rationing.

[3] I do not think they will rise enough, because in the standard formulation the unemployed are still ‘enjoying’ their additional leisure. One day macroeconomists will feel able to note that in reality most view the cost of being unemployed as far greater than its pecuniary cost less any benefit they get from their additional leisure time. This may be a result of a rational anticipation of future personal costs (e.g. here or here), or a more ‘behavioural’ status issue, but the evidence that it is there is undeniable. And please do not tell me that microfounding this unhappiness is hard - why should macro be the only place where behavioural economics is not allowed to enter!? (There is a literature on using wellbeing data to make valuations.) Once we have got this bit of reality (back?) into macro, it should be much more difficult for policymakers to give up on the unemployed.

References (some with links in the main text)

Olivier Blanchard & Jordi Galí (2010), Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment,  American Economic Journal: Macroeconomics, vol. 2(2), pages 1-30

Hansen, Gary D (1985) “Indivisible Labour and the Business Cycle” Journal of Monetary Economics 16, 309-327

Hansen, Gary D and Wright, Randall (1992) “The Labour Market in Real Business Cycle Theory” Federal Reserve Bank of Minneapolis Quarterly Review 16, 2-12.

Pascal Michaillat (2012), Do Matching Frictions Explain Unemployment? Not in Bad Times, American Economic Review, vol. 102(4), pages 1721-50.

Shimer, R. ‘Labor Markets and Business Cycles’, Princeton, NJ: Princeton University Press, 2010.