Bad Luck
As Bruce Bartlett will tell you, the conventional wisdom among Keynesians during the 1970s was that the rising inflation rate in the US during that decade was primarily the result of a string of unlucky events – oil shocks, a bad anchovy harvest, and so on. Among Keynesians today, the conventional wisdom is that their predecessors were wrong and that the rising inflation rate during the 1970s resulted from excessively loose policy. The problem is, from a Keynesian point of view, today’s conventional wisdom doesn’t make quantitative sense.
Under the Keynesian paradigm, a loose policy can be defined as one that tends to push the unemployment rate below the non-accelerating inflation rate of unemployment (NAIRU), so that inflation will tend to accelerate. Conversely, a tight policy can be defined as one that tends to push the unemployment rate above the NAIRU, so that inflation will tend to decelerate. Whether the unemployment rate is in “loose” or “tight” territory, the economy will be subject to shocks (bad luck – or good luck), which may cause the inflation rate to do something else, but these shocks cannot be blamed on (or credited to) policy. (Also, there may be shocks in the policy transmission process that prevent the unemployment rate from reaching its intended level in the first place, but these aren’t the type of shocks that people have in mind when discussing the 1970s.)
The average unemployment rate for the US during the 1970s was 6.2%. Until the mid-1990s, conventional estimates put the NAIRU at about 6%. Using the conventional linear approximation to the Phillips curve, this means that policy, on average, managed to push the unemployment rate to a level that should have resulted in a slight decline in the inflation rate. On average, policy was tight, not loose.
If anything, this simple analysis underestimates the extent to which policy was tight. The 6% NAIRU estimate came with full benefit of hindsight. An estimate produced using data available during the mid-70s would put the NAIRU somewhat lower. So if we describe policy in terms of its actual intentions, rather than the results that might have been anticipated with benefit of hindsight, it was more than a little tight.
This is not to say that policymakers (meaning the Fed) necessarily acted appropriately during the 1970s. Perhaps, in the interest of restoring the credibility they lost during the Johnson-Nixon years, they should subsequently have been even tighter than they were. Perhaps high inflation is just bad and should have been met aggressively at every turn, even when it was not the result of recent policy. But leaving these normative issues aside, it’s hard (at least if we accept the Keynesian paradigm) to see how, in the absence of considerable bad luck, the inflation rate at the end of the 1970s could have been so much higher than it was at the beginning. Did anyone notice a black cat on Constitution Avenue?
Under the Keynesian paradigm, a loose policy can be defined as one that tends to push the unemployment rate below the non-accelerating inflation rate of unemployment (NAIRU), so that inflation will tend to accelerate. Conversely, a tight policy can be defined as one that tends to push the unemployment rate above the NAIRU, so that inflation will tend to decelerate. Whether the unemployment rate is in “loose” or “tight” territory, the economy will be subject to shocks (bad luck – or good luck), which may cause the inflation rate to do something else, but these shocks cannot be blamed on (or credited to) policy. (Also, there may be shocks in the policy transmission process that prevent the unemployment rate from reaching its intended level in the first place, but these aren’t the type of shocks that people have in mind when discussing the 1970s.)
The average unemployment rate for the US during the 1970s was 6.2%. Until the mid-1990s, conventional estimates put the NAIRU at about 6%. Using the conventional linear approximation to the Phillips curve, this means that policy, on average, managed to push the unemployment rate to a level that should have resulted in a slight decline in the inflation rate. On average, policy was tight, not loose.
If anything, this simple analysis underestimates the extent to which policy was tight. The 6% NAIRU estimate came with full benefit of hindsight. An estimate produced using data available during the mid-70s would put the NAIRU somewhat lower. So if we describe policy in terms of its actual intentions, rather than the results that might have been anticipated with benefit of hindsight, it was more than a little tight.
This is not to say that policymakers (meaning the Fed) necessarily acted appropriately during the 1970s. Perhaps, in the interest of restoring the credibility they lost during the Johnson-Nixon years, they should subsequently have been even tighter than they were. Perhaps high inflation is just bad and should have been met aggressively at every turn, even when it was not the result of recent policy. But leaving these normative issues aside, it’s hard (at least if we accept the Keynesian paradigm) to see how, in the absence of considerable bad luck, the inflation rate at the end of the 1970s could have been so much higher than it was at the beginning. Did anyone notice a black cat on Constitution Avenue?
Labels: Burns, economics, inflation, macroeconomics, monetary policy, NAIRU, Phillips curve, unemployment
posted by knzn at 4/13/2007 08:14:00 AM
8 Comments:
The problem with this line of though is that inflation expectation plays a very significant role in the wage setting mechanism and in the 1970s this was constantly rising and more then offsetting the tightness -easing implied by the NAIRU.
Spencer, I agree that the inertial inflation rate was rising during the 1970s due to changes in expectations. But I don’t think it’s reasonable to define a neutral policy as one that offsets changes in the inertial inflation rate. In that case, a neutral policy during the 1970s would have to have been one that intentionally produced and prolonged recessions. Surely, from a Keynesian point of view, that’s not a reasonable concept of a neutral policy. Rather, one should say that the Fed did follow (on average) a moderately tight policy when circumstances called for a very tight policy. But remember, at the time, there were also many people who questioned whether the high inflation rates were really so terrible. Seems to me it is just our 21st century values that tell us that circumstances called for a policy to keep inflation down.
Another issue, which I didn’t bring up in the post, is the inconsistency of policy. If (as suggested by most charts I’ve seen of static Phillips curves, and as must be true when U approaches zero) the Phillips curve is convex, then a steady, moderately tight policy would have been much more effective than the dramatic shifts that took place (by almost any measure) from very loose to very tight to very loose. I don’t think one can blame the Fed’s general ease for the rising inflation rates, but one can perhaps blame its inconsistency.
You are completely right.
I've always said the Fed is independent in the government,
not independent of the government.
It reads election results like the supreme Court does and gives us the policy we want. Until inflation reached double digit rates the political system -- general public was not ready to pay the price for lower inflation.
"Another issue, which I didn’t bring up in the post, is the inconsistency of policy. If (as suggested by most charts I’ve seen of static Phillips curves, and as must be true when U approaches zero) the Phillips curve is convex, then a steady, moderately tight policy would have been much more effective than the dramatic shifts that took place (by almost any measure) from very loose to very tight to very loose."
I think this is pretty much the pov Alan Blinder took in "Central Banking in Theory and Practice", if I remember corrctly. And he is pretty much the archetypus of a Keynsian,
I agree that inconsistency can be a problem, particularly when the average Joe knows too little about the underlying fundamentals and is trying to formulate or adjust expectations.
Off topic:
I'm just curious... what would a Keynesian say about the costless disinflations that followed the adoption of "inflation targeting" in several countries, both developed and transitions?
Well, this Keynesian would be skeptical as to whether empirical data really show the disinflations to be costless (relative to the counterfactual of no disinflation). But generally, I think, in a New Keynesian framework, disinflation could be costless if it’s fully anticipated. For example, if you’re a price-setting agent that faces menu costs, you’ll be only too happy to stop raising prices as long as you expect everyone else to do so.
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