A breath of fresh air from John Cochrane
By Scott Sumner
Over at TheMoneyIllusion I’ve been running a series of posts that are critical of popular views of inflation. I claim inflation is determined by shifts in the supply and demand for money, and that factors like the Phillips curve and interest rates are not central to the inflation process. Think of money supply and demand models as fundamental, and Philips curve and interest rate models as contingent.
John Cochrane makes some similar arguments, although he uses a very different theoretical framework:
Why is it so hard? The standard story goes, as there is less “slack” in product or labor markets, there is pressure for prices and wages to go up. So it stands to perfect reason that with unemployment low and after years of tepid but steady growth, with quantitative measures of “slack” low, that inflation should rise, as Ms. Yellen’s first quote opines.
That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get “tight,” companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company’s products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor’s prices are all rising does nothing to get it to produce more.
This is one of those cases of two things that look superficially similar but are actually radically different, like eels and snakes. When money became very tight in 1921, 1930, 1938 and 2009, the equilibrium price level fell sharply. Nominal wages also needed to adjust downwards. Unfortunately, nominal wages are sticky, so wage growth slowed much too gradually to prevent high unemployment. Thus even though nominal wage growth slowed in all four cases, real wages actually increased sharply. Cochrane’s right that the wage changes we see in this sort of labor market have nothing to do with microeconomic models where a high level of demand means rising prices and a low level of demand means falling prices. Those micro models refer to real or relative prices, not nominal prices.
So why do wages often rise quickly during “tight labor markets”? One reason is that because wages are sticky, when they are rising they (paradoxically) tend to be too low, and when they are falling they tend to be too high. Suppose 10% of worker contracts are adjusted to equilibrium each month. Then if a sudden monetary shock causes the equilibrium wage to immediately rise by 4%, wages would rise 0.4% after one month, 0.8% after two months, and reach the new equilibrium after 10 months. Again, when you see wage growth accelerating then wages are often too low, and when you see wages falling they are often too high.
Now we can see the connection between rising wages and tight labor markets. When wages are rising they are too low—and those excessively low real wages cause companies to want to hire more workers—hence the high level of employment. It has nothing to do with tight labor markets causing higher wages—as Cochrane says that’s an example of the fallacy of composition. And that’s why it’s not a reliable model of inflation–it’s not a causal factor.
There are many more gems:
By the way, the oft-repeated mantra that “inflation expectations are anchored” offers no solace. In fact, it makes the puzzle worse. The standard Phillips curve says inflation = expected inflation – (constant) x unemployment. Variation in expected inflation is usually an excuse for a Phillips curve failure. Steady expected inflation means the Phillips cure should work better!
Is policy tight or loose right now?
You’d think this were an easy question. The newspapers ring with “years of extraordinary stimulus” and “unusually low rates.” And indeed, interest rates are low by historical standards, and relative to rules such as John Taylor’s that summarize the successful parts of that history.
But ponder this. What does a central bank look like that is holding interest rates down? Well, it would be lending out a lot of money to banks, who would turn around and re-lend that money at higher interest rates. What does our central bank look like? Our central bank is taking in $2.2 trillion from banks, and is paying them a higher interest rate than they can get elsewhere. Right now, the Fed is paying banks 1.25% on their reserves. But Treasury bills are 1%. Even commercial paper is 1.13-1.2%. It looks every bit like a bank that is pushing rates up. And has been doing so for a long time.
It’s good to finally see a prominent economist point out that monetary policy has not been easy, a point I’ve made about 1000 times since 2008.
Cochrane ends with this:
If you just plot inflation and interest rates, they seem to move together positively. Teasing out the notion that higher rates lower inflation from that graph takes a lot of work. My best guess, merging theory and empirical work, is that higher rates — moved on their own, not in response to economic events — temporarily lower inflation, but then if you stick with higher rates, inflation eventually rises. And vice versa, which accounts for very low inflation after interest rates have been stuck low for a long time. Maybe yes, maybe no, but even this much is not certain.
Finally I’ve found something to criticize. This paragraph perfectly encapsulates what’s right and what’s wrong with NeoFisherism. Cochrane is right that higher rates often are associated with lower inflation in the short run, but higher inflation in the long run. But he stills falls a bit short in my view.
Let me start by quibbling over a minor point—Cochrane’s reference to interest rates moving “on their own”. I think I know what Cochrane means, but I’m going to throw a temper tantrum anyway, and then explain why.
Interest rates never move around on their own, as the economy is not some sort of Ouija board where things happen “on their own” without there being an “economic event”, to use Cochrane’s terminology. Now I’m pretty sure that what Cochrane meant by “on their own” was a change in the interest rate caused by monetary policy. But that doesn’t help as much as you might assume.
When Cochrane said that higher interest rates may initially reduce inflation, he probably had in mind a contractionary monetary policy. But in that case it’s not the higher interest rates that lower inflation, it’s the monetary policy. Thus a sudden decrease in the monetary base is contractionary, and may lead to both higher interest rates in the short run and lower inflation. Ditto for a higher interest rate on reserves. (The interest rate paid on reserves is not really a market interest rate, it is an administered price (subsidy).) For any given monetary base, a higher fed funds rate is inflationary, as it boosts velocity (assuming no IOR).
When Cochrane refers to a policy of “sticking with higher rates” he runs into problems. As noted, he seemed to start by considering a contractionary monetary policy that led to higher interest rates in the short run. But if you “stick with” a contractionary monetary policy then rates will end up lower over time. It makes no sense to talk about “sticking with” higher interest rates, because interest rates are not a policy, they are the effect of various other policies.
To get higher rates to persist you’d need to switch from a very contractionary to a very expansionary policy. But that switch will often temporarily depress interest rates, before causing them to rise. A good example occurred in 1967, when rates temporarily fell (easy money) before rising to semi-permanently higher levels during the Great Inflation of 1966-81. That persistent inflation is what NeoFisherians have in mind when they equate a high interest rate policy with high inflation. It’s a valid point, and an important critique of Keynesian economics. But unless and until the NeoFisherians fully incorporate both the liquidity effect and the Fisher effect into their models, the analysis will remain frustratingly incomplete. And to do that we need to return to monetarist economics, something neither Cochrane nor his New Keynesian critics seem to have any interest in doing.
HT: Tyler Cowen