IAS 107: Intermediate Macroeconomics: April 5, 2011 Monetary Policy Lecture
Department of "Huh?!": Ken Rogoff Edition

IAS 107 Intermediate Macroeconomics March 29, 2011 Inflation Lecture Cleaned-Up Transcript

IAS 107 Intermediate Macroeconomics March 29, 2011 Inflation Lecture Cleaned-Up Transcript

J. Bradford DeLong
U.C. Berkeley

Welcome back from spring vacation. There are five more weeks left of classes--and there is still a lot to do.

Picking up the threads, we are still thinking about situations of inflation. We have left depressions and deep downturns like the one we are currently in behind. We have left long-run growth behind. We are dealing with the economics of inflation.

Right now, at least here in the United States, the economics of inflation is rather boring. There isn't any inflation. If anything, our inflation rate is too low, not too high. But there have been periods in the past when figuring out how or whether to control or reduce the rate of inflation has been the most important economic policy issue. And there may well come times in the future when the same is the case. That is why we are spending time on inflation economics in this course.

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You will recall that our consumer price index has risen by a factor of 10 since 1950: $10 today buys about as much as a dollar did in 1950. Of course, $10 a day buys you very different things than $1 bought you in 1950. Yesterday I was on Bloomberg TV with Columbia Business School Professor and former Federal Reserve Governor Rick Mishkin. Rick said that in his new house--I presume it is a large new house, for if he wanted a small house he would be living in a townhouse in Manhattan--he has bought an inordinate number of large screen TVs. Why? Because, he said, they were a lot cheaper than art, and he had to hang something on the walls.

I now have this image of Rick Mishkin's house filled with 60-inch flatscreen TVs with the sound off, all tuned to the Nature Channel. And I draw two conclusions. First, there is definitely a market opportunity for an art channel--or, rather, many art channels. Second, consumer electronics today are extraordinarily, bizarrely cheap--and if you like them, you are in hog heaven.

What we buy now is very different than what we bought back even a generation ago. The Bureau of Labor Statistics has to try to do the best job it can of figuring out what has happened to the "average" level of prices in spite of these enormous shifts in relative prices.

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Last time we talked about the burst of inflation during the Korean War, inflation's falling back, and then rising to a new peak during the Vietnam War. And then came the tripling of world oil prices after the 1973 Arab-Israeli war. And then came the Iranian Revolution. The result was the peak of inflation in the early 1980s, after which the Federal Reserve acquired essentially unlimited power to manipulate the economy however it waned without interference or, indeed, much criticism in the interest of avoiding another outbreak of inflation like the 1970s.

Looking at the past generation of inflation, we see a minor uptick in the late 1980s after Alan Greenspan responds to the stock market crash of 1987 by saying, "Uh-oh, I need to make the money stock grow faster. Maybe the stock market crash is going to produce a depression." Monetary ease turned out not to be necessary to prevent a depression. Instead, Greenspan found that had he pumped too much liquidity into the economy, and he had to raise interest rates sharply and bring about a small recession to bring it under control.

Most recently we see our current episode, in which the Federal Reserve wishes that it had been trying to make inflation higher in the mid-2000s in order to cushion the downturn. Worrying about inflation right now is not quite like crying "Fire! Fire!" in Noah's Flood. But it is close.

And last time we talked about Okun's Law--the relationship between real GDP and the unemployment rate. When real GDP is growing rapidly, unemployment falls. When real GDP is growing slowly or shrinking, the unemployment rate rises. Generally you have to keep track of one but not of both unemployment and real GDP relative to potential because of this Okun's Law relationship. And, largely for historical reasons, when we think about inflation we focus on the unemployment rate. The unemployment rate relative to the natural rate of unemployment is a good stationary measure of how much slack or pressure there is in the economy--to what extent the economy is producing in a subnormal condition with lots of idle resources, or to what extent people are scrambling for resources and production is at a level that will prove sustainable. And that got us to the inflation-unemployment relationship, to the Phillips Curve

The Phillips Curve tells us that inflation is in large part a result of expectations. The inflation rate is going to be what people expect it to be, plus or minus a "pressure" term equal to a parameter β times the difference between the natural rate of unemployment to the actual unemployment rate.

π = E(π) + β(u*-u)

When the actual unemployment rate is low, inflation is going to be running ahead of expectations. When the actual unemployment rate is high, inflation is going to be less than expectations.

Thus there are two ways that a central bank like the Federal Reserve that wants to control inflation can actually act to affect it. The first is for the Federal Reserve to do what's called "jawboning": it controls inflation by using its jawbone, by talking. It tries to convince people of what the future is going to bring, and so of adjust their expectations of inflation toward what the Federal Reserve wishes to be the case.

The second thing the Federal Reserve can do if the inflation is higher than it wants to see is for it to hit the economy on the head with a brick. Raise the short term nominal interest rates it controls. That will raise long term real interest rates. That will push down investment spending and exports down. Boosted by the multiplier, that will push real GDP down. That will push the unemployment rate up. With businesses finding themselves with lots of idle capacity and few markets, they won't charge high markups over cost. With workers scared of losing their jobs because unemployment is high, they won't ask for wage increases. Thus the Federal Reserve can bring inflation down, if it really wants to.

A few words about "expected inflation." It is a subtle and fuzzy concept. It is everyone's expectation, and it's something that's formed over a considerable period of time. Right now, my wife and I are paying an interest rate on our home mortgage that we took out 15 years ago. When we were making our economic decision to buy the house 15 years ago, we were thinking what's the inflation rate going to be over the next 30 years. And because we locked in a contract back then, what we expected inflation to be 15 years ago still enters into the market's expectation of inflation today. Expected inflation is an average of all the expectations that people have held into the past, taken at the time they were taken, included to the extent that they still affect what's currently going on in the economy.

Can "jawboning" work? Yes. The classic example comes from Weimar, Germany in 1923 and 1924. The German government in the end stopped the hyperinflation not by printing less money--as NYU's Tom Sargent pointed out, they printed more money faster after the end of the hyperinflation than before--but simply because they changed the name of the currency and made people believe that the hyperinflation was over, that in the future things were going to be different.

Why people believed that things were going to be different is an interesting question. But controlling inflation through "jawboning" is, or at least can under some circumstances be, effective.

Back to the Phillips Curve, which says that inflation depends on what people expect inflation to be and also on the rate of unemployment: when the unemployment rate is high, inflation will be lower than expected; when the unemployment is low, inflation will be higher than expected.

Here once again is the picture of inflation and unemployment in the United States since World War II.

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Here are all the data points for the 1960s: all the data points up through the end of Richard Nixon's first year as president. You can see a clear and strong downward relationship here. You can look at this and you can say, "Hmm, it really looks like the expected rate of inflation is something like 2% and the natural rate of unemployment is something like 5.5%." You have some years in which that is the case. And then you have some years in the late 1960s when times are good in the sense that unemployment is low, is below the economy's natural rate of unemployment, but you pay a price for this because you have higher inflation. During the Vietnam War years, especially, people say, "Hmm, the labor market is tight, I can ask for more wage increases" and "Hmm, the product market is tight, I can charge higher margins." And those things push inflation up above the value that people generally expected it to be. But in the 1960s you do not have any big changes in expectations of inflation. Even near the end of the 1960s, it looks as though people are still expecting inflation to be 2% per year.

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When Richard Nixon takes office his economic advisors, chiefly Herbert Stein, Milton Friedman, and Alan Greenspan, tell him: "We are going to have to let the unemployment rate go back up to something like 6% or so if we want to get inflation under control. If not, if we keep running the economy with the unemployment rate at 4%, sooner or later, people will stop expecting 2% inflation. And when they stop expecting 2% inflation, we're going to see inflation expectations rise. And then both inflation and unemployment will rise. We do not want to go there."

Nixon agrees. And things start out relatively well in the 1970s. The administration lets the Federal Reserve tighten to raise interest rates and unemployment, and it looks as though the economy moves back down the Phillips Curve.

Note that it is not the same Phillips Curve that we saw in the 1960s. Instead of touching 2% inflation when the unemployment rate was 5.8%, you get to 2% unemployment only with an unemployment rate is 6.7%. It would probably be better to say that in the early 1970s inflation expectations are 4% rather than 2%.

And it is at this point that the consensus is that Richard Nixon's desire to get reelected enters the story. Nixon had been Dwight Eisenhower's vice president in the 1950s, and was an extremely unusual politician--you can see his portrait in our Institute for Governmental Studies. Although Nixon had been Eisenhower's vice president for eight years, Eisenhower didn't like him very much. Eisenhower would end press conferences when people asked, "Well, what important decisions of the administration has Richard Nixon played a significant role in?" with quips like, "Well, if you give me a week, I might be able to think of one. Ask me that question next week."

Richard Nixon deeply believed that if the party in power was trying to win reelection with a high unemployment rate, things were likely to go badly. Come the winter of 1960 Richard Nixon and his friend Arthur Burns went to Eisenhower and Eisenhower's cabinet saying: "Hey, it looks like we're having a small recession right now. We don’t want the economy to be in recession on November 1960 when election day comes around do we? Please do something so I don't have to run against John F. Kennedy in September and October with Kennedy saying the republicans have done a horrible job at the economy. Look, the unemployment rate is up 6%."

And Eisenhower says no.

Richard Nixon loses the 1960 presidential election to John F. Kennedy by the very narrowest, narrowest of margins.

If you go and if you read Nixon's autobiography "Six Crises," he talks unashamedly about how if only and Burns had managed to get Eisenhower to do something to boost the economy, he would have won the election of 1960.

So now, it is 1971, and while the inflation rate is coming down the unemployment rate is at 6% or so. Who is president? Richard Nixon. Who does Nixon appoint to chair the Federal Reserve Board? Arthur Burns. What does Arthur Burns do?...

Expectations of inflation start to take off.

People say: "In the 1960s we were fooled. We didn't understand the government was following policies that would push the unemployment rate down and produce higher inflation. Now we do, we're not going to get caught out by this. We're going to raise our expectations of inflation as fast as the government can pursue stimulative policies to reduce the unemployment rate."

Add to this the 1973 tripling of world oil prices, which also raises everyone else's expectations of inflation.

By late 1973, the economy is up here with 10% inflation and 5% unemployment. And in 1974 Gerald Ford becomes president and makes his highest priority to Whip Inflation Now: W.I.N. Republicans wander around Washington wearing W.I.N. buttons. The Federal Reserve tightens. There is a steep--for the day--recession. But inflation only falls back to 6% or so. And at this point the Carter administration takes office as Jimmy Carter runs against Gerald Ford for presidency ontwo major issues. The first was that Gerald Ford was picked by Nixon the liar. The second is that the Republicans have mismanaged the economy: the Misery Index, the sum of the inflation and unemployment rate, is at sky high levels because the Republicans have clearly mismanaged the economy.

Carter's economic policy team decides to pursue a policy of "gradualism." They hope that they can gradually recover from the recession and gradually reduce inflation expectations. And they were wrong--especially after the additional tripling of world oil prices because of the Iranian Revolution. Come 1979 the United States is stuck with unemployment about at its natural rate of 5% or so, about at the level at which there's neither upward nor downward pressure on inflation from unemployment, and an inflation rate up at 12%.

This is the point at which Jimmy Carter names Paul Volcker to head the Federal Reserve, and Paul Volcker says this has got to stop. America cannot afford a situation where not only are expectations of inflation high, but expectations of inflation are increasing. If people were expecting 4% inflation in the early 1970s and expecting 8% inflation in the mid 1970s, they were expecting 11% inflation in 1980 and were on a trajectory to expecting 15% inflation come the mid 1980s.

At this point Paul Volcker assembles the rest of the Federal Reserve behind him. He says: "We are just going to hit the economy on the head with a brick. We are going to push unemployment up high above 10%. We are going to keep it there and show people that we are serious about fighting inflation until expectations of inflation fall."

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And he did.

During the initial stages of the Volcker disinflation, the economy moves back along its early 1980s Phillips Curve. Unemployment rises. Inflation falls but only because Volcker has hit the economy on the head with a brick, creating lots of unemployed workers willing to work for less. But as inflation expectations fall, Paul Volcker allows the unemployment rate to fall. By 1987 when leaves office, the inflation rate is down to 3.5 and the unemployment rate is down to 6.5%.

It is at that point that Alan Greenspan takes over as chair and thinks: "Hmm, there's been the stock market crash, maybe there's a depression threatening, I'm going to let inflation fall or unemployment fall faster than Volcker did and see what happens." And indeed, he lets inflation fall faster than Volcker did--and the inflation rate starts rising again back towards 6%. Then Greenspan reverses course. He raises interest rates and pushes unemployment up.

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In the process, he makes it harder for George H.W. Bush to win reelection, and Bush does not--a thing for which the Bush family has never forgiven Alan Greenspan. Talk to Bush family retainers about Alan Greenspan--it is extraordinary.

But Greenspan's reversal of his expansionary course did anchor inflation expectations. And once Alan Greenspan has everyone's attention, he finds in the 1990s that he can let the unemployment rate fall gradually as inflation expectations fall. By the end of the 1990s, we're back essentially to where we were at the start of the 1960s: everyone expecting low inflation around 2% or so, and with a relatively stable Phillips Curve.

And things change again in 2008. The unemployment rate starts to rise like a rocket. It rises far that by now the Phillips Curve is telling us to expect the inflation rate to be -2% or so. But we're not there. We're still stuck here with inflation of maybe 1%, 1.5% even though unemployment is still nearly 9%.

Why is this the case? Is it the case that people now expect inflation to be 4%? What seems to happen is that this Phillips Curve relationship breaks down when the rate of inflation gets very low.

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The best hypothesis I've heard for why it isn't true comes from Yale economist Truman Bewley: It is true that people are unhappy if their wage increases don't keep up with the rate of inflation--if inflation is 4% and you get an only 1% wage increase, you're unhappy. But people are furious if your boss cuts your wages--if inflation is 1% and they cut your wages by 2%, you're not just unhappy, you're enraged. There's something about cutting the number of dollars that you're going to be paid for doing the same work in the American psyche that gets people really angry, and makes them really unwilling to put in the effort to be good workers.

And so, Truman Bewley argues, because each company know that cutting people's wages is a way to guarantee that they'll do a lousy job, businesses are overwhelmingly unwilling to cut people's wages at all. They would rather fire more people. And so the Phillips Curve model breaks down whenever you get into situations like we are today, where the inflation rate is very, very low.

The takeaway is that while the general Phillips Curve model for inflation economics is useful, it is fragile. Come the late 2000s and today's situation and the model simply breaks down.

But we think we won't always stay at unemployment of 8.8% or higher forever Things will get better. And when we get back to a more normal unemployment rate, we can bet that the expectational Phillips Curve relationship will reemerge.

So why does all this matter? Should we really care about inflation? If wages and prices rise at about the same rate, why is inflation a problem at all? Wny would anybody deliberately do what Paul Volcker did in 1980, deliberately trigger a very nasty episode because he thinks inflation needs to be reduced?

Back at the start of the 1980s, Paul Volcker and his peers on the Federal Reserve Open Market Committee did explicitly seek to raise unemployment rates to purge inflationary expectations out of the economy. They thought having an economy in which the inflation rate is 4% or 3% or 2% was a very valuable thing as opposed to an economy where the inflation rate was 10% or 15% or 20% per year.They thought that throwing a lot of Americans out of work for a long time was an acceptable price to pay for achieving this particular goal.

One reason is that inflation distorts what your view of the world is. A market economy works by people using prices to calculate what they ought to do and what things were valuable. An ongoing process of inflation makes all these calculations difficult. Thus inflation deranges the price system.

Inflation is also unjust. Let's listen to John Maynard Keynes on this:

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.

The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers,' who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.

As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose...

So it looks as though John Maynard Keynes would have approved of the Volcker disinflation.

But the big reason why governments act like the way that Volcker did is that inflation is politically unpopular. It was Jimmy Carter's chief economist Arthur Okun who decided to run against Gerald Ford by talking about the Misery Index--the sum of inflation and unemployment. And Ronald Reagan and his economic advisors did the same thing to Jimmy Carter four years later in 2000 when things were considerably worse. In Britain Labour party leader James Callaghan was defeated a year or two before Jimmy Carter by the Conservatives precisely because of inflation. By contrast, both Ronald Reagan and Margaret Thatcher win reelection in the early 1980s, even though unemployment was considerably higher, in substantial part because inflation was lower. Sharp reductions in inflation lead the voters to vote with their feet for Reagan and Thatcher for their reelection against Walter Mondale on the one hand and Michael Foot of the Labour Party on the other.

These things made governments think that central banks ought to act to keep inflation low whenever they can--and also politicians would rather that central banks just do what has to be done and not talk to them too much. They want low inflation. They don't want to be on the hook for the decisions necessary to achieve it.

I was going to end this lecture with a brief survey of the Federal Reserve System. I was going to say the Federal Reserve Board consists of a chairman who has a four-year term, a vice chair who has a four-year term and of five other members of the board of governors. There also are the 12 presidents of the regional Federal Reserve banks, who sit as voting or non-voting members on the Federal Reserve's chief decision making body, the Federal Open Market Committee.

I was going to say that the chairman of the Federal Reserve Board is the chairman of the Open Market Committee, but the vice president of the Open Market Committee isn't the vice chair of the board. The vice chair of the Open Market Committee is the president of the Federal Reserve Bank of New York. And I would say that five members of the Federal Reserve Board are voting members of the Open Market Committee and the other seven non-voting members. The president of the Federal Reserve Bank of New York is always a voting member of the Open Market Committee. Of the other 11 regional bank presidents, at any one point in time, only four will vote. The president of the Federal Reserve Bank of San Francisco gets to be a voting member of the FOMC only once every three years. How do you choose four from 11? Well, the Federal Reserve Bank of Cleveland and Chicago are special. Their presidents get to be voting members every other year as opposed to once out of every three.

But I don’t have time to do any of this. So we will pick up the threads on Thursday.