Targeting wage inflation

I was pleased to see that David Blanchflower and Adam Posen have advocated using wage inflation as an intermediate target in their analysis of labour market slack in the US. Specifically they say

“Our results also point towards using wage inflation as an additional intermediate target for monetary policy by the FOMC, paralleling on the real activity side the de facto inflation targets on the price stability side.”

I have periodically argued for wage inflation targets in the case of the UK, but both their and my arguments are universal.

My own argument for targeting wage inflation has been a combination of theory and practicality. As I have often pointed out, there are good theoretical arguments for targeting alternative measures of inflation besides consumer prices. The way macroeconomists usually measure the cost of inflation nowadays is to score the distortion to relative prices created by the combination of general inflation and the fact that different prices are set at different times. The ‘ideal’ price index to target would be one that gave a higher weight to prices that changed infrequently, and a low weight to those that were changed often. Wages are just another price in this context, and they are changed infrequently.

The practical argument is that if we had been targeting wage inflation over the last few years, monetary policy would have worried less about the temporary inflation induced by shocks such as commodity price increases or sales taxes. Here is a chart of recent and expected wage inflation (compensation per employee) from the OECD. 

In normal times we would expect 2% price inflation to be associated with something like 4% wage inflation because of productivity growth. Wage inflation has not come close to that number in recent years in the UK, US or the Eurozone. It is difficult to see how the ECB could have raised interest rates in 2011 - as they did - if they had had wage inflation as an intermediate target.

The argument put forward by Blanchflower and Posen is rather different, because they associate wage inflation with the real side of the dual mandate in the US. To quote:

“wage inflation should be considered as the primary target of FOMC policy with respect to the employment stabilization side of the Fed’s dual mandate, at least for now. Unlike unemployment, the rate of wage inflation requires less judgment and is subject to less distortion by such factors as inactivity. At least four of the labor markets measures that Yellen cites as worth monitoring- unemployment, under-employment of part-timers, long-term unemployment, and participation rate- reveal their non-structural component by their influence on wage growth. And that is what the Fed should be trying to stabilize along with prices.”

To paraphrase, unemployment (or anything similar) can become distorted as a measure of labour market slack, but wage inflation is a good indicator of the true state of the labour market.

I would add one final point. The spectre that seems to haunt central bankers is the inflation of the 1970s. That has to be avoided at all costs. Yet the 1970s was associated with what was called a wage-price spiral: both price inflation and wage inflation rising rapidly, and a feeling that this was a contest between workers and firms that neither could win, but where society was a loser. If we want to avoid a wage-price spiral happening again, it is only logical that we look at wages as well as prices.

My verdict on NGDP Targets

At the beginning of the year I decided I needed to firm up my views on nominal GDP (NGDP) targets, and when I thought it was interesting track that process through blog posts. I think I have now done enough to reach a tentative conclusion. I also gave a policy talk at the Bank of England yesterday, which was a useful incentive to get my thoughts in order.

Here is a link to the slides from my presentation. What I first do is compare targeting the level of NGDP to an ideal discretionary monetary policy. That is a demanding standard of comparison, but I argue that NGDP targets have the potential advantage over discretion that they may allow central banks to pursue a time inconsistent policy after inflation shocks that would otherwise be politically difficult (see this post). More speculatively, the uncertainty for borrowers of NGDP variation may be more costly than uncertainty over inflation, as Sheedy argues (see this post).

Against these advantages, I see two major negatives. First, following a shock to inflation, I think NGDP targets would hit output more than is optimal (see here and here). Second, if there is inflation inertia (inflation depends on past inflation rather than expected inflation), then targeting the level of NGDP is welfare reducing, because it is better in that case to let bygones be bygones. (There is a related point about ignoring welfare irrelevant movements in non-core inflation, but that probably needs an additional post to develop.)

So far, so typical two handed economist. But now let’s shift the comparison to actual monetary policy, rather than some ideal. Or in other words, how does actual policy as practiced in the UK, US and Eurozone compare to an ideal policy? While NGDP targets may well hit output too hard following inflation shocks (and more generally gets the short run output inflation trade off wrong), current policy seems even worse. One interpretation of this is that policymakers are obsessed with fighting what they see as the last war. Outside the US this is often institutionalised by having inflation targets (even if they are flexible) rather than a dual mandate, locking in the error Friedman complained of during the Great Depression.  As attitudes or institutional frameworks are unlikely to change soon, moving to NGDP targets represent a move towards optimality.

This bias in policy is particularly unfortunate when we are at the zero lower bound (ZLB), because unconventional monetary policy is far less predictable and efficient. Although fiscal stimulus is likely to be less costly as a way of raising output at the ZLB than committing to higher future inflation, monetary policy has to work with fiscal policy as it is. (However policymakers have a responsibility to let the public know when inappropriate fiscal policy is making it difficult for monetary policy to meet its objectives, as Bernanke is now doing, but the Bank of England has not. As for the actions of the ECB in encouraging austerity at the ZLB, I have described the gravest macroeconomic policy errors as those that are both wrong and contradict the textbooks.)

With perverse fiscal policy and uncertain unconventional monetary policy, we need to raise inflation expectations as a means of overcoming the ZLB and raising demand. Here I agree with Christina Romer: we need to indicate something rather more fundamental than the kind of marginal change implied by the forward guidance we currently have in the US and are likely to have soon in the UK. My proposal is therefore the adoption of a target path for the level of NGDP that monetary policy can use as a guide to efficiently achieving either the dual mandate, or the inflation target if we are stuck with that. NGDP would not replace the ultimate objectives of monetary policy, and policymakers would not be obliged to try and hit that reference path come what may, but this path for NGDP would become their starting point for judging policy, and if policy did not move in the way indicated by that path they would have to explain why.

To some supporters of NGDP targets this advocacy may seem a little wimpish. Why limit NGDP to an intermediate target that can be overridden? Given the problems with NGDP targets that I mention above, it would I believe be foolish to force monetary policymakers to follow them regardless. In general I think intermediate targets should never supplant ultimate objectives, and NGDP is an intermediate target. The analogy I would draw is with monetary targets as adopted by the Bundesbank, and as briefly adopted in the UK. As I wrote here, most readings of Bundesbank policy suggest that they treated money targets pretty flexibly. Following the oil price shocks of the mid 70s and early 80s, inflation did rise substantially, but the target ensured that inflation came back down again. In contrast the UK adoption of money targets was far less flexible, so we had inflation overkill in the early 80s, and these targets were quickly dropped.

How was this proposal received by my audience at the Bank? Did my reasoning stand up to their criticism? Well at least one of the slides I would change in hindsight, but perhaps all that is best left for a separate post tomorrow.

The long run government debt target

In a recent post I had an imaginary interviewer asking “But surely no government can keep on borrowing more forever.” To which my suggested reply was “Of course not. But the right time to cut government borrowing is when the economy is strong, and the cost of borrowing is high.” This prompted a little discussion in comments about the long run desirability or otherwise of government borrowing. What I have to say here is only about the long run, and has no immediate relevance while we are still in a recession.

I have to stress here that by long run, I really do mean very long run. It is the period to which Keynes dictum applies. Why? One of the most robust ideas when it comes to government debt is that it should adjust very slowly, and absorb any shocks coming from the economy along the way. The reason, which is just tax smoothing, I have discussed at greater length here. Which prompts an obvious question: if any long run debt target is meant to be achieved in centuries rather than years or decades (I did say very long run), do we need to worry too much about it? This turns out to be a rather good question.

What little literature there is on this issue contains the ‘steady state random walk debt’ result. What this means in ordinary English is that it can be optimal to have no target for government debt. Perhaps a better way of putting it is that the costs of adjusting towards any target outweigh the long run benefits of achieving it. Imagine a recession raises debt. To get debt back down we need to increase taxes in the short run by a lot. Alternatively we could make no attempt to reduce debt, but instead just raise taxes by enough to pay the interest on the extra debt. That will mean raising taxes by less, but having to do so forever. So in one case (debt targeting) taxes rise by a lot in the short run, but not at all in the long run, while in the other (debt accommodation) taxes rise by a little forever.

You might think the second (debt accommodation) alternative must be worse, because the pain is ever lasting, but you would be forgetting about discounting. Which is better depends on the size of the discount rate relative to the size of the real interest rate. It turns out that if the two rates are equal, the second alternative (debt accommodation) is optimal. And it just so happens that in our benchmark macroeconomic model, where agents care about their children and so effectively live forever, the two rates are indeed equal.

Obviously this ignores default, which might put an upper limit on debt. There are other, potentially important, caveats, which I have discussed elsewhere. However the basic result relies on the exact equality of the discount rate and real interest rate. If the real interest rate is even slightly greater than the discount rate, and there are good reasons for thinking in the long run that it might be, then it makes sense to adjust to a debt target, although the adjustment should be very slow. So what should this target be?

The simplest answer is also the most extraordinary – the government should aim to hold assets, not debt. The long run debt target should be negative. The reason is that with lots of assets, the government could pay for all its spending out of the interest on those assets, and as a result taxes could be abolished. Well, maybe not all taxes: some are designed to influence incentives. But most taxes are designed to raise revenue, and these distort incentives, so if we could get the revenue another way that would be great. (Even if you think the preoccupation of many economists with the negative incentive effects of taxes is overdone, it must be worrying that in the US the costs of complying with individual and income tax requirements for 2010 has been estimated to be 1% of GDP.)  

Now many of you will think that I’ve entered that imaginary world that is the one economists like to dream about, but which is a million miles from reality. If so, have a look at this chart, which is of government net financial liabilities in 2007, before the recession. (Source OECD Economic Outlook)

Norway is a special case, of course, but note Australia, Denmark, Finland.... Now I do not know much about the reliability and comparability of these net debt figures, but Australia’s gross debt was less than 15% of GDP in 2007, and both they and New Zealand had a clear policy to reduce debt towards zero, although for different reasons than the one suggested above.

Turning government debt into assets may seem an impossible goal now, and it is a goal we should be ignoring in a recession. However once the recession is over, and given that adjustment should be very very slow, it is not so obviously a ridiculous target.  If we combine incredibly slow adjustment with an incredibly ambitious target, we might end up with something reasonable – which is to aim for a gradually falling debt to GDP ratio once the recession is over.

There are lots of qualifications I would want to throw at this result, but this post is already long. (Those who are interested can read this working paper.) The only one that I have come across which completely overturns this idea is the literature on safe assets, but that definitely requires another post. So let me end instead with an amusing (at least to me) little story. I was recently giving this working paper in a UK economics department. One of the department’s members is a well known and for me inspirational macroeconomist, but notoriously right wing. At first he liked the message of my paper, which was that government debt should come down. Until, that is, he saw where it was leading – to an economy where the government owned a large proportion of assets, and therefore inevitably a large proportion of the capital stock. I think this had unfortunate resonances for him!