Not sure why the Fed made a commitment to increase inflation despite mixed signs of a recovery in the US economy? Good. Edward Price, a former British economic official and current professor of political economy at the Center for Global Affairs at New York University, explains the paradox at the heart of the US central bank’s new monetary framework.
Erwin Schrödinger, physicist, has studied every thing. And he discovered something weird. If observed, the atomic world will change state. Schrödinger illustrated this idea with an imaginary cat. In an irradiated box, and as long as this cat remains invisible, it can remain both dead and alive. It is only when the box is opened that his real fate will occur.
Which is ridiculous. Schrödinger himself admitted this. He hoped his thought experiment would illustrate the absurdity of the opinions of other quantum scientists. But, as a theory, it is neither more nor less ridiculous than some traditional economics.
This includes ideas that are at the heart of the models of monetary policy makers.
Take the Phillips curve. He postulates an inverse relationship between inflation and unemployment. Simply put, the more people who have jobs, the more money there is in the system. This, in turn, should mean a higher rate of inflation. For many years, the Phillips curve was considered a science of economics. But then, in the late 1960s, Milton Friedman treated the curve to a savage dismantling. He showed that policymakers cannot rely on the trade-off between wages and prices – injecting inflation to reduce unemployment – because workers will notice what they are doing and demand better pay as a result. Eventually, he argued, inflation will exceed job gains, which happened in the 1970s. Moreover, the Phillips curve does not explain situations where inflation and unemployment are low, for example in the first quarter of 2020.
Yet none of these flaws, it seems, has really knocked the inflation-employment tradeoff off its golden pedestal. The theory is still referenced today, especially by central banks. Today, for example, market attention has focused on non-farm payroll figures. Those numbers were appalling, with the US economy adding only about a quarter of expected employment gains.
Given concerns about the ability of the US economy to recover, Jay Powell, Chairman of the Fed, made it clear that the Fed will provide support “as long as it takes” to achieve a buoyant labor market and , with him, to inflation. At first glance, there is nothing wrong with it. As part of the Fed’s contract with the government, it must produce two things: stable prices and full employment. But, at a second glance, that mandate seems at odds with Friedman’s description of the Phillips curve. Full employment is supposed to give up stable prices and vice versa.
To get around this, the Fed has concocted two conceptual hacks.
The first is the unaccelerated unemployment inflation rate, or NAIRU. A mouthful, NAIRU simply refers to the idea that in any stable monetary system some people will naturally have no jobs. In return, there is no need to seek full employment in the proper sense.
The other leeway comes from an equally playful definition of stable prices. The Fed and other central banks cannot pursue nominal price stability. This would require an entirely static monetary system in equilibrium with an entirely static economic system. Which is impossible. Instead, a slight reminder to get out and spend – the loss of real purchasing power, which comes with a little inflation – is best.
However, this loss of real purchasing power has largely escaped central banks in recent times. This is despite U3, the most commonly used measure of unemployment, falling to levels consistent with NAIRU.
Which is why the Fed dropped its old framework last year and adopted a Flexible Average Inflation Target (FACT), under which it can tolerate inflation above its 2% target for (a indeterminate period). The objective is twofold and simple. No more inflation and, with that, more jobs. In other words, if inflation is so consistently low, the notion of NAIRU must go.
This is where things get weird.
The proposed mechanics of FACT is an affirmation of Phillips curve theology. In other words, DONE assumes that the curve is alive and well. More inflation will mean more jobs. But, at the same time, it is only possible to adopt DONE because the Phillips curve is dead. And monetary policymakers killed him. Without the still low inflation of the monetary authorities, no central banker would dare to embark on a wave of deliberate and sustained inflation.
So what is it? Is the Phillips curve alive or dead?
On the one hand, alive. In combination with the current and proposed fiscal stimulus in the United States, which accounts for nearly a quarter of U.S. GDP, the central bank could have a pretty good chance of producing a price hike. On the other hand, dead. Today’s nonfarm figures were appalling. If the conclusion is that we’ve been measuring unemployment wrong all this time, and for some reason inflation remains low, we can indeed say goodbye to NAIRU.
This is the riddle at hand. The Fed’s position only makes sense because the natural unemployment rate is both known and unknown.
Economists have long been accused of envy of physics or of the desire to predict macroeconomics as reliably as physicists predict natural phenomena. But the most compelling parts of physics and economics have nothing to do with Newtonian mechanics. Instead, people are like atoms. Interact with them and things invariably get weird. The macro cannot be extrapolated from the microscopic, at least not before the event. For the dominant balance theory, this is a bitter red pill. But it seems the Fed has swallowed it up, moving from a slumber of dark science to a far stranger reality.
Welcome to the weird and wonderful world of quantum central banks.
Farewell to forward guidance to the Fed – FT Alphaville