I thought it might be useful to provide a bit of data context for my post on central bank mandates. What did we think we knew about unemployment and inflation?
I often hear people saying that the experience of the 70s refuted the whole notion of a Phillips curve. No, it didn’t. What it did was show that unemployment wasn’t the only determinant of current inflation; expected future inflation is also crucial.
And what the Phillips curve with expected inflation implied was “clockwise spirals” in unemployment-inflation space. Suppose you came into a recession with, say, 10 percent inflation. This inflation rate would fall in the face of high unemployment — and expected inflation would eventually fall too, so that when unemployment fell again inflation would remain lower than it was pre-recession (until the next boom).
Both the slump of the mid-1970s and the slump of the early 80s fitted this pattern, but the recent slump has not:
So why the difference? Some people have pointed to the failure of inflation to fall by a lot as evidence that the NAIRU — the non-accelerating-inflation rate of unemployment — has risen sharply, so that America is now at more or less full employment.
But I’m in the camp that says that the expectations-augmented Phillips curve breaks down at low inflation rates, thanks to nominal wage rigidity. It’s one thing to squeeze inflation down from 10 percent to 4 percent; squeezing it down from 2 percent to 0, or even deflation, would require that lots of workers take actual wage cuts — and that’s something that tends not to happen. Instead, we find ourselves with many workers having zero wage change, while some have gains, so that wages overall continue to rise, and so does the overall price level.
It’s important to note that this isn’t an after-the-fact rationalization. As I’ve tried to point out, people like Pierre Fortin (for Canada) and George Akerlof warned about this effect long before the Great Recession.
And what this says is that price stability isn’t an adequate guideline for monetary policy. You can have stable prices and a persistently depressed economy.