Central bankers have one job and they don’t know how to do it

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

–Former International Monetary Fund Chief Economist Olivier Blanchard

The Phillips curve is just not very important as part of the inflation process.

–Federal Reserve Governor Lael Brainard

Rightly or wrongly, most central bankers think their mission is to keep the growth rate of consumer prices slow and stable. Even in places, such as America, that also ask the central bank to promote “maximum employment”, the inflation mandate is paramount.

The standard argument is that unemployment and living standards are real things outside the purview of the monetary authority, whereas “inflation is always and everywhere a monetary phenomenon”.

The problem is no one seems to have figured out how central bankers are supposed to influence this “monetary phenomenon” using the tools at their disposal.

That, at least, was one of the main takeaways we had from the Peterson Institute’s latest conference on “Rethinking Macroeconomic Policy”. (This was the fourth edition of the conference, which had previously been run by the IMF. We’ll cover other aspects of the fascinating event in subsequent posts.)

Even leaving aside the Neo-Fisherians*, who were not represented at Peterson, the disagreement between Blanchard and Brainard illustrates the magnitude of the problem.

Blanchard’s view is the bog-standard framework embraced by Fed boss Janet Yellen, Vice Chairman Stanley Fischer, and others:

The jobless rate affects the wage gains workers can demand from employers
People bargain over nominal incomes, rather than real incomes
Extra money given to workers is spent on consumer products, driving up prices
Businesses in the aggregate aren’t limited in their ability to raise pay or hike prices

The first claim is relatively uncontroversial, although history is littered with examples of employers using violence to extract labour from workers to offset “tight” job markets. Despite that caveat, it remains safer to assume that workers fare better when unemployment is low than when it is high. The debate is about claims 2-4.

There isn’t much evidence that people care more about nominal wages than real spending power, at least on the way up. (On the way down you could have a situation where nominal wages fall but the cost of living falls further, in which case you end up with rising real incomes and ballooning debt burdens.)

Household spending tends to track wages, but the relationship is loose. Savings rates can swing wildly. People also change how much they spend on “consumption” (things tracked in the inflation index, such as televisions and trips to the dentist) relative to “investment” (things that aren’t, such as houses, jacuzzis, and cryptocurrencies).

There is at best a tenuous connection between what most people think they spend on and what makes up the bulk of the inflation index. About half of what’s in the Fed’s preferred price index is divorced from actual consumer spending decisions.

(Around 21 per cent of America’s personal consumption expenditures deflator is health care and pharmaceuticals — even though most of that spending is done by opaque intermediaries rather than price-conscious consumers. About a sixth is “owners’ imputed rent” plus “financial services furnished without payment”. Groceries and energy prices are more affected by changes in global supply and demand for commodities than domestic wage factors. All data come from table 2.4.5 of the National Income and Product Accounts.)

Claim 4 is the weakest of the bunch. Blanchard’s — and Yellen’s — narrative only works if money and credit expand. Low unemployment and restive workers by themselves aren’t sufficient. Otherwise you end up with companies forced into bankruptcy by high wage bills and intolerable debt burdens, as in the early 1980s.

It shouldn’t be surprising this old-fashioned view fails to fit the data. Yet this model remains popular with many top officials.

Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.

Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.

Brainard recognises the problem. She is willing to acknowledge the decades of data disproving the model favoured by Blanchard, Fischer, and Yellen — even though this leaves her without a quick and ready way to explain where inflation “comes from”. (Empirically, the best predictor of future inflation is past inflation, with no insight gained by adding in the unemployment rate.)

The challenge for her — and for everyone else who wants central banks to do the one thing they say they should be expected to do well — is to figure out what should replace the Phillips Curve framework. It’s appealing to say you will control inflation by controlling unemployment because it sounds straightforward. The problem is it’s bogus. Reality is a lot more complicated.

Maybe the answer is to ditch the focus on inflation and replace it with a more holistic measure of macro stability, as Raghuram Rajan suggested? Maybe governments need to be more aggressive in adjusting their tax and spending policies to offset the limitations of the interest rate tool, as Larry Summers and others argued? Or maybe something even more radical is required, such as the creation of individual accounts at the central bank that could be topped up by regular amounts? Either way, something has to change.

*Scholars such as John Cochrane and Stephen Williamson argue that real interest rates are not a policy variable, except perhaps during short periods. Instead, real rates are determined by market forces and the state of the economy. This is analogous to the conventional claim that central banks can’t affect productivity or unemployment outside of cyclical fluctuations.

According to their interpretation of standard models, “pegging” nominal short-term interest rates at a given level for long enough will eventually force inflation to either slow down or speed up. Counter-intuitively, a sustained commitment to keeping policy rates at zero could actually cause disinflation, while raising interest rates could cause inflation to accelerate. This is the opposite of how most central bankers and monetary economists think of things.