A closet NGDP targeter?

In his letter to the Chancellor, Sir Mervyn says (pdf) “it is…possible that inflation could fall back more sharply given the existing margin of spare capacity in the economy.”

That word “possible” is doing quite a bit of work. My chart shows why. It plots core inflation (excluding energy, unprocessed food and taxes) against the unemployment rate, lagged 12 months, since 2002. If spare capacity tended to push inflation down, you’d expect to see an orthodox downward-sloping Phillips curve. But you don’t. Instead, it looks as if there are two vertical curves. There the 2002-07 one, which saw unemployment around 5.3 per cent, and there’s a post-2008 one, with unemployment around 8 per cent.

The data seems more consistent with the Nairu increasing in the crisis, rather than with spare capacity depressing inflation.

After all, we’ve had high unemployment for two years now, and yet core inflation, at 2.2 per cent on this measure, is above its 10-year average.

What’s going on here? I suggest three elements:

1. There’s a mismatch between spare capacity and demand. In Arnold’s terms, the patterns of sustainable specialization and trade have been jumbled up. A newly unemployed civil servant in London, for example, cannot easily become an engineer in Aberdeen. Unemployment can therefore exist alongside rising cost pressures in some sectors.

2. The financial crisis was a supply shock. To see what I mean, consider why spare capacity should bear down on inflation. One reason is that it makes markets more contestable. Spare capacity enables a firm to expand quickly and cheaply. It thus encourages firms to cut prices in order to win more orders. Alternatively, it compels firms to hold prices down in order not to be undercut by potential rivals. But what if firms can’t get the finance to expand or - what is overlooked - are unwilling to borrow for fear that the credit line might be later withdrawn? In this case, spare capacity won’t encourage expansion and thus won’t encourage price cuts.

3. Price wars are cyclical. In a famous paper (pdf) written in 1986, Julio Rotemberg and Garth Saloner showed that price wars were more likely in booms than slumps. The time to cut prices is when there are lots of customers to be won - and this is not in a recession.

If all this is right, then we shouldn’t expect core inflation to collapse. Yes, overall inflation will drop for mathematical reasons as last winter’s rises in VAT, food and petrol prices drop out of the comparison. But perhaps inflation will stay above target*. There is a middle way between the gold bugs who somehow think QE will be hugely inflationary and the agg demanders who expect inflation to slump.

All of which raises a question. If spare capacity isn’t very disinflation, why does the Bank seem to think otherwise?

Here’s a thought. Believing that a weak economy leads to significantly lower inflation allows you to relax monetary policy substantially whilst claiming to stick to inflation targets. But in fact, what you are really doing is targeting real economic growth instead. Maybe the Bank has been a closet nominal GDP targeter all along. After all, this - more than inflation - justified its superloose policy in 2008-09 and its recent resumption of QE.

* A caveat here is that the spare capacity might exist within firms, because of labour hoarding, and so not show up as unemployment.

Comments

[Rob]

Scott Sumner claims that one of the biggest benefits of NGDP targeting comes from the stabilisation of NGDP growth expectations. Or, to paraphase Dr. Strangelove, the whole point of NGDP targeting is lost if you keep it a secret. Why doesn't Mervyn King tell the world?

[chris]

He can't tell the world coz the job of choosing the monetary framework is the govt's, not his, and this is a political fight best avoided.
Yes, expectations matter. But you could easily argue that the Bank has been trying to raise growth expectations, and thus animal spirits, thus doing what Sumner thinks NGDP targeting does.

[NM]

Chris, a lot of the aggregate demand reasoning is coming out of the US where the inflation story is very different from here. What we need to work out is why the UK is so different in this regard. It can't just be down to VAT and a falling value in the pound.

[farmland investment]

This post seems to take a sober middle ground, which is a refreshing change of pace. I have seen quite a few posts in the blogosphere stating that QE will be massively inflationary. However, this ignores the fundamental point that if banks are not lending and consumers and businesses are too broke or cautious to borrow, than all of this extra QE cash will just sit on banks balance sheets since the transmission mechanism to the real economy will be effectively broken. The hyperinflationists just do not seem to understand this fairly basic point. Than again yelling "hyperinflation is coming" does make for good copy!

[Daina Van Been]

I am not a specialist so my opinion is not one of interest, but what bothers me really is the problem with economy today and more specifically if the problems in Greece will influence the whole union.

[Paolo]

Point 2 and 3 are linked. Spare capacity enables all competitors to increase output quickly, hence you have the kind of price wars in time of subdued demand which can be mutually damaging for firms competiting against each other just to maintain their market share (the price war among supermarket is a case in point). So I am not sure that this spare capacity argument is convincingly micro-founded.

Which brings me to your point about animal spirits. Under expactations of increased inflation debt-laden consumers will respond by tightening up even more to service their outstanding debt, and this is particularly the case given that average salaries are not adjusting for inflation. This in turn is making deleveraging even harder on a forward-looking basis, which would tend to depress demand further. So how is this supposed to stimulate animal spirits?

The main reason why the BoE is so keen to keep rates low is to avert people with flexible rate mortages to go into negative equity. No need to try to justify it otherwise.

[Miguel Madeira]

And a graphic comparing, not unemployment with inflation, but unemployment with the variation of inflation?

[Frank H Little]

What does the chart look like when you strip out food prices?

[Rob]

Paolo: "average salaries are not adjusting for inflation"

I think you mean that average salaries are not rising faster than the rate of inflation, not that they're not adjusting at all. If we had lower inflation, we'd probably have even lower salary rises (or none at all).

It's easy to point at the inflation bogeyman and claim that inflation is to blame for falling purchasing power, but the real problem is falling real incomes. Real incomes could fall with zero inflation - firms could freeze pay or cut wages or, if all else fails, cut staffing levels. Inflation allows firms to retain more workers by giving them a real-terms pay cut despite nominal pay rises. To the extent that inflation has any real effect, a fairly brief burst of modest (5%) inflation is likely to have positive effects in our present situation.

The counterfactual scenario is not one where QE did not happen, inflation stayed under 2% and wages rose above 2%. The counterfactual is one where inflation stayed low and a lot more people lost their jobs. The pernicious effects of this scenario seem, to me, to be greater than the one we're living in right now.

[Paolo]

@ Rob, from last Inflation report, wage growth of 2.3%, RPI of 5.4% - that's less than half the rate of inflation, let's not get stuck into semantics.

You say that if salary adjusted for inflation (in full) than there would have been more job cuts. I am saying that unless salaries rise in term of spending power, the economy will be stuck - since the export drive doesn't seem to be working. Let's not forget that firms are doing very well profit-wise and have lots of cash (in aggregate).

To me if salaries continue to decline in real terms the pernicious effects will persist and worsen.

There is only one way out of this. The trend where the GDP quota of salaries is in decline need to be reversed. You tell me how you propose to do that leaving it to the BoE alone and supply-side "structural" reforms.

[Rob]

I agree, salaries worsening in real terms is a bad thing. My point was simply that the level of inflation tells you nothing about what's happening to real incomes, and that real incomes can be in a very bad position even with very low inflation.

I also agree that salaries should rise as a proportion of GDP (or rather that I'd prefer to live in a world where this happened). Accomodative monetary policy should support this goal, and supply-side reforms might help; our main problem is that the left has basically abandoned both fields to the right.

Anti-monopoly policies are "supply-side", policies to increase business formation and to make it easier for cooperatives to operate are "supply-side", one can even argue that the welfare state is "supply-side" in the sense that it lowers the risks associated with activities like founding a business (in practice it's actually quite unfriendly to people who do this, but that needn't be so). Some barriers to growth exist simply to protect incumbent companies and their shareholders, and removing them is both a left-wing and "supply-side" objective.

Likewise, monetary policy is not inevitably right-wing. It has to be predictable, stable, credible and rules-based, but that's about it - there's no reason why you couldn't have rules that are more favourable to left-wing goals. Indeed NGDP targeting is regarded as more favourable to left-wing goals because it increases the emphasis on economic growth and decreases the emphasis on inflation-fighting-at-all-costs.

[Bill le Breton]

I am sure King is a 'closet NGDPer'. But because the mechanism works through expectations, being in the closet reduces the efficiency of the policy. He may reason that without political protection, if he came out of the closet, the hawks would come down on him like a ton of bricks.
If King is a NGDPer, does Osborne realise this? Is Osborne complicit or unenlightened? Have most decision takers 'read' the Governor anyway?
Have Liberal Democrats in the Coalition realised that they could be the means of a necessary communications campaign?
They seem to be hitching their wagon to Prof Crafts http://www.ft.com/cms/s/0/f8498e3e-0eb9-11e1-b83c-00144feabdc0.html but is he a price level targeter rather than an NGDP targeter.

[Gareth]

I don't think it's King who is the closet NGDP targeter, I think it's Charlie Bean. It's Bean who talks up the effect of QE on nominal spending.

Worth remembering that in the early 1980's the govt was effectively targeting NGDP because they thought velocity was constant, and they set targets for growth of M. They simply weren't very good at it hitting the targets, and V was not constant after all.