Where does the FOMC get these ideas?

We all know that Janet & Friends are trigger-happy, dying for a plausible excuse to begin the so-called “rate lift-off”. We also know that the labor market is the “star of the play”, being groomed to be the signal that will open “heaven´s gate”!

The “grooming” has changed “styles”. Initially it was 6 to 6.5 “inches” and over the past couple of years has been “trimmed” down to 5 to 5.2 “inches”.

How do they know that´s the “in style”? They don´t, really. They thought it was also “in” almost 20 years ago when Janet was not yet the Head-dresser. In 1997, together with like-minded “fashion guru” Laurence Meyer, she was advising Greenspan that he should raise rates because unemployment was too low! Larry described the “hair style” in detail in April 1997. You can easily see that the playbook today is the exact same:

I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.

There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.

Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool(!) in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate. But, it should also be noted that monetary policy has responded appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect, implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed as following a procedure like the time-varying parameter estimation technique applied by Robert Gordon and others.

We were all very lucky that Greenspan didn´t “buy” their suggestion at the time. Unfortunately, now Janet is the Head-dresser, and has enticed others who appear to be like-minded, or that have come on board simply because that´s the best bet available to “open heaven´s gate”.

Look at their “drawing-board”:

Janet´s Salon_1

You can easily understand why the first “style” was 6 to 6.5 “inches”. That´s the unemployment point below which wages began to rise. However, that was during the years before the Fed messed-up, when it strived to keep nominal spending on an “even keel”.

When it did mess up, although unemployment rose, wage growth didn´t budge for quite some time (the flat part of the blue line). That´s evidence for wage stickiness!

When wage growth finally dropped, it´s growth remained about the same even though unemployment was falling. As required by the “playbook”, Janet is adjusting (“trimming”) her estimate of NAIRU to reflect incoming data.

Now we are at the April 2015 point (red). Janet´s view is that if unemployment crosses the “Rubicon”, wages will “take-off”. How fast they have no idea. I do.

Given the level and the rate at which nominal spending has been growing (4% and likely falling), wage growth will likely increase very little.

Why all the anxiety about the impact of wage growth on inflation? It´s a fixed and longstanding image in Janet´s head. Ordinary mortals’ can´t see it!

Janet´s Salon_2

What will happen? More likely they´ll keep “trimming” the NAIRU estimate “to reflect incoming data”.

3 thoughts on “Where does the FOMC get these ideas?

  1. Prof. Nunes, really great post. I was wondering if the 2012-2015 yellow dots could be split in two, what I am looking for is if the yellow dots within the “trimming” area are separated in time from the yellow dots outside the “trimming” area. If the dots within the “trimming” area follow in time the other ones, they clearly show the period of time when money was too tight, no? Just wondering…

    • JRR, they do follow in time (from right to left). But I don´t think that distinguishes a period of tight MP, simply because MP was tight over the whole period!

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