Friday, June 09, 2006

If not NAIRU then what?

Already, I realize I’m going to have to start spacing out my NAIRU posts, or I’ll have to change the name of this blog to “NAIRU and…” But the NAIRU wars continue, and this is a good time for my first substantive post on the subject.

In my first reply to Angelica (Battlepanda) in the comments to the link above, I conclude:

But eventually, at some point, you will have to raise interest rates. How do you determine that point, and why? Whatever answer you give will imply some theory about the way the world works, and it may or may not be a better theory than the NAIRU. If we don’t know what the theory is, though, we’ll probably never know if it’s a better theory.

Here I will suggest and comment on some possible alternatives, to argue (briefly) why I think they are not sufficient to make the NAIRU theory obsolete:

1. intuition.

First of all, this is a nice trick if you can do it. If you can clone Alan Greenspan ad infinitum, we’ll probably be fine. Otherwise, I’m not so sure. Among ordinary mortals, intuition can be severely clouded, for example, when the man who appointed you is a corrupt megalomaniac who thinks the future of the free world depends on his being reelected.

Second of all, “intuition” really begs the question. “Intuition” means either that you have a theory you don’t know how to express (or can’t explain why you believe), or that you have several theories you are weighing in your mind. In Greenspan’s case it was maybe a little of both. Though Greenspan publicly disavowed the starkest version of the NAIRU theory, there was surely some version of the theory in the witch’s brew of theories that informed his intuitive decisions. And the Fed’s course in the late 90s seems pretty close to optimal (at least if you don’t think they should worry about asset bubbles). If Larry Meyer and his fellow NAIRU advocates hadn’t been there to toss in some eye of newt, the brew might not have had the right effect.

2. downward-sloping long-run Phillips curve

This is the theory that prevailed before the NAIRU unseated it. Personally, I think economists were too hasty to reject it. The inflation of the 1970s provided a strong emotional argument against the old theory, but the inflation had various other contributing causes (e.g., OPEC, a tumultuous labor market, a corrupt megalomaniac working with an intuitive Fed chairman) besides a possibly bad theory that might have distorted policy. But good luck trying to convince just about any other living economist today to resurrect the old Phillips curve! It’s like trying to sell whiskey to a Salvation Army general.

3. privatized monetary policy

The Austrian school argues (IIRC) that we should get rid of the Fed altogether and let banks create their own money, secured by the credibility of their promise to pay in gold (or in something else of value). This is a really bad idea. Don’t even get me started.

4. monetary aggregate targeting

Been there. Done that. The results weren’t pretty. And that was before the last 20 years of financial innovations, which have further softened the links between nominal income and the money supply. Like the downward-sloping long-run Phillips curve, this is an idea that has been tried and rejected, but in this case I agree with the consensus. (By the way, anyone who is familiar with the career of Milton Friedman will see a certain irony in proposing monetary aggregate targeting as an alternative to the NAIRU theory.)

5. real business cycle theory

I doubt that anyone who reads this blog will seriously suggest using this as a primary guide to policy, but I include it because it’s still the most academically respectable alternative to the NAIRU. If anyone does think this is the way to go, I’d be interested to hear details.

6. commodity targeting

This is what supply-siders tend to like, but I notice they tend to change their minds about which commodities to target depending on what policy implications suit their current fancy. I think it’s a very bad idea anyhow. Over the last few years, for example, various commodity prices have been rising rapidly. If our currency were tied to those commodities, we would be contracting the money supply and deflating the rest of the economy. Of course, we could have chosen commodities that don’t happen to be rising now, but then some other day we’ll have the same problem. (And if we’re allowed repeatedly to change which commodities to target, then this is no policy at all.)

7. Taylor rule without an output term

In other words, raise interest rates when the inflation rate goes up, and get more aggressive the more it goes up. I guess this is the most obvious, and the most widely acceptable, alternative.

But it’s a dumb idea. Implicitly, it’s based on a theory that is even dumber than the NAIRU theory: namely, that next year’s inflation rate equals this year’s inflation rate (plus some completely unpredictable random change). The implication is that economists who forecast inflation have been complete failures and should be replaced by someone who just copies a number from one spreadsheet cell to another. That’s just not true: while they haven’t done nearly as well as one might hope, they haven’t completely failed.

There is plenty of information (the unemployment rate being the most obvious example) that can help forecast inflation, and the Fed should take advantage of that information. For Heaven’s sake, if the unemployment rate goes down to 3%, I don’t care if you see any new inflation yet; you’ve gotta raise interest rates! And if it goes up to 9%, I don’t care if you don’t see the inflation rate falling yet; you’ve gotta cut interest rates!

8. any other ideas?

I have some that I like, but that’s for another post. (And I’m really talking about ideas derived from the NAIRU theory, anyhow.)

UPDATE: OK, I was a little unfair to the Taylor rule (7). Obviously there has to be some feedback from monetary policy to inflation; otherwise nothing the Fed did would have any effect. So the implied theory is not quite as degenerate as I suggested. However, it is essentially saying that the process by which monetary policy affects the inflation rate is a “black box,” the contents of which we know nothing about. That’s just silly.

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Anonymous Anonymous said...

I recently reviewed a text that
completely omitted the possibility
of a NAIRU. I suggested that this might make the book a difficult sell to a "mainstream"

Fri Jun 09, 10:35:00 AM EDT  
Anonymous Anonymous said...

The whole point of the Taylor principle is that it constrains the off-equilibrium-path behavior of monetary policy in order to avoid sunspots. The implicit assumption here is in some kind of short-run Phillips curve--a surprise burst in inflation causes the Fed to raise interest rates more than one for one, raising real interest rates, lowering output, and bringing inflation back down. An output (or unemployment) term in a Taylor rule might make some sense, but the primary point is to keep us out of an unstable equilibrium path.

Of course, my criticism of that is that if one were to raise interest rates too slowly in a well anticipated manner, the Fisher principle starts to kick in, giving us higher inflation. Also, this principle might fail to be a useful guide in a model with a richer role for money, such as providing a transactions technology to consumers or liquidity to firms. In that kind of world, keeping nominal interest rates near zero in the steady state makes sense.

The thing that baffles me about the current set of rate hikes is the idea that a nominal interest rate of 5% is neutral. Ignoring taxes for a minute, real interest rates on gov't debt are at about 2%, which means that a neutral inflation rate is about 3%. This is about what we've had over the past year. This also explains how Japan had nominal interest rates of zero and slight deflation in the 1990s.

Makes me want to take up labor and do IVs all day, doesn't it?

Fri Jun 09, 11:46:00 AM EDT  
Anonymous Anonymous said...

"First of all, this is a nice trick if you can do it."

Greenspan literally use to call firms up and ask them re inflationary pressures etc. Much of his analysis was groomed from cocktail party chatter. Data is the plural of anecdote.

"Personally, I think economists were too hasty to reject it."

There are two problems with it. Its wrong in theory and its wrong in practice. Need I say more?

"By the way, anyone who is familiar with the career of Milton Friedman will see a certain irony in proposing monetary aggregate targeting as an alternative to the NAIRU theory."

Monetarists said, well, just keep money growth equal to potential output growth (assuming price stability). I dont see how this is inconsistent with a Nairu.

"If anyone does think this is the way to go, I’d be interested to hear details."

RBC said, well, theres no nairu. What is, *is* efficient. However, they did not really say money didnt matter. Money is important to maintain a stable economic environment to ensure free markets worked well. Indeed, thats why (they claim) RBC works so well since monetary policy improved. So RBCers would be for inflation targeting, but not for targeting the employment growth etc. Indeed, with the so-called "divine coincidence" a stable inflation rate is consistent with unemployment at the NAIRU. So, in theory, I wouldnt reject this out of hand. (RBC actually fits the data remarkably well, given its simplicity. I used to be dismissive of it myself, but Im reconsidering.) Even DeLong says its a good theory for booms.

"that next year’s inflation rate equals this year’s inflation rate (plus some completely unpredictable random change)."

I think inflation did follow a random walk for quite a while. Larry Ball has a paper on this, if youre interested. But, I think theres a consenus, that expected inflation is adaptive.

"by which monetary policy affects the inflation rate is a “black box,” the contents of which we know nothing about. That’s just silly."

This is Krugmanesque (saying something unfounded with supreme self-assurance and dismissing others as silly. Huh.). Everyone agrees that monetary policy works with "long and variable lags". This sounds pretty much like a "black box" to me.

(you should read up on the "divine coincidence". It basically says; target inflation and youll hit the nairu automatically. I think youd find it interesting, knzn)

Sat Jun 10, 12:30:00 PM EDT  
Blogger knzn said...

Anonymous (mvpy, is that you?),

Long and variable lags are not the same as a black box. First of all, the length of the lags has nothing at all to do with the blackness of the box. The variability of the lags suggests (but doesn’t absolutely imply) that the box is not perfectly transparent, that our view of the stuff inside is imprecise; it certainly does not imply that we cannot see inside the box at all.

Divine coincidence is a separate issue. The fact that a certain model may exhibit divine coincidence does not imply that there is no role for intermediate indicators like unemployment in the process of targeting inflation.

It really is entirely implausible to me (in my earlier words, “just silly”) that inflation itself would be the only indicator of potential inflation that the Fed could usefully employ. The strict “Taylor rule without an output term” approach throws out not just the NAIRU but also monetarist theory and every other substantive theory of inflation that includes empirical referents other than the interest rate. The output term in the usual Taylor rule is really a way of summarizing all the information that we do have to help anticipate changes in the inflation rate. It may not be the best way of summarizing that information, but that doesn’t mean the information doesn’t exist.

Sat Jun 10, 01:48:00 PM EDT  
Anonymous Anonymous said...


Yes that was me. Anyway.

Regarding your black box thing, Im not convinced. Okay, for starters, theres the long and variable lags. Right. But aside from that, theres enormous uncertainty about the monetary policy channels per se. The interest rate channel? The lending channel? The credit channel? Exchange rate channel? Equity market channel? And so on.
I dont think theres any consensus on all of this. Indeed, I think that while the "interest rate channel" is the textbook benchmark, Im not fully convinced this is that important. What with the imprecision of *how* monetary policy works coupled with *how long* it takes to work, I stand by the "black box" analogy. Rather like the A, in growth theory, mind you. We know its important, but thats we dont know how to exploit that fact for operational purposes.

My ideal policy is this: sure, we dont know the nairu or potential etc. But, we've got a great way to find out: just watch inflation! So, just watch inflation and follow the Nike strategy; just do it. If inflation is rising, then we're above potential (below the Wicksellian int rate) so, raise rates. And conversely.

Sat Jun 10, 06:00:00 PM EDT  
Blogger knzn said...

You don’t need consensus. You can have 20 different theories and assign subjective probabilities to them and calculate an expected inflation rate. If the Fed does this, they’re going to come up with a better inflation forecast than if they just assume a random walk. The fact that different people draw different conclusions when they try to look inside the box does not mean the box is completely black.

Moreover, for any given theory, you don’t need to know the monetary policy transmission mechanism. You just need to know what, according to the theory, is going to happen before inflation rises.

Why observe just inflation when you can also observe leading indicators of inflation? Sure, they won’t be as reliable as you might like. But is it reasonable to say that the Fed should have precisely zero confidence in such indicators?

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