Please, give the Fed a timeless rule

In an interesting post “A kink in the Phillips curve”, Nick Bunker finishes off:

The graph shows the relationship between wage growth for production and non-supervisory workers, and the employment rate for prime-age workers six months prior. It clearly shows that when the labor market is tighter (when the employment rate is higher), wage growth is stronger.

Time Invariant Rule1

In other words, the underlying idea of the wage Phillips curve still stands. It’s just a matter of using measures that fit the time.

As Matt Phillips (no relation to William presumably) points out in his Quartz piece on the curve, the labor market has changed quite a bit since the mid-1970s. He points specifically to the decline in the unionization rate, which is a sign of the decreasing bargaining power of labor in the economy. A 5 percent unemployment rate when labor is relatively much stronger, for example, is very different from a 5 percent unemployment rate when labor is on the back of its heels. Changes in the labor market might be a reason why increases in wages and salaries don’t pass through to overall inflation as much as we might have thought. Back when labor had more bargaining power, wage hikes would bite more into profits and therefore spur companies to raise prices. Now companies have more of a cushion, so a similar wage increase won’t necessarily lead to as strong of a price increase.

Context appears to very much matter. Policymakers will always need to create rules of thumb to help them make sense of an incredibly complex economy. But those rules need to be updated as the world changes.

That´s all very nice, but is it useful? In other words, can´t we come up with a “rule of thumb” that is “timeless”?

The NGDP-LT growth rule may qualify. In the chart below, I use the same graphic strategy, but instead of charting wage growth and the prime-age employment population ratio, I substitute wage growth for NGDP growth.

Time Invariant Rule2

It appears that what´s driving both the employment ratio and wage growth is NGDP growth. While during the “Great Moderation” (“GM”), NGDP growth evolved along a stable level path, by letting NGDP growth crash in 2008-09, the Fed afterwards put it on a lower path, which is why I name it the “False GM”.

The coincidence of the fall in the employment ratio to the crash in NGDP growth makes the argument that the fall in the employment ratio is mostly due to structural/demographic factors hard to swallow.

In his post, Nick Bunker says “but those rules need to be updated as the world changes”. He´s referring to adopting a modified Phillips Curve (PC) concept. Unfortunately, that likely won´t help. Over the last 50 years, no relation has been more modified, refined and specified than the PC, and it still doesn´t work!

As I argued in another post, it is time to abandon “estimation” and do some “experimentation”. The chart gives a clear pointer: try putting NGDP growth on a higher path. The result will likely be a higher labor force participation and higher wage growth. If it is done right, inflation getting “out of hand” shouldn´t be a worry!

The chart below shows how the Fed was successful in bringing the NGDP growth path down to conquer inflation and reap the Great Moderation. Now it has to do the opposite and make the red band look more like the green band!

Time Invariant Rule

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.