February 26, 2007
Has The NAIRU Gone Away?
For decades, a simple rule has governed how the Federal Reserve views the nation's economy: When unemployment falls too low, inflation goes up, and vice versa.
... From 1979 to 2003, Fed Chairman Paul Volcker and his successor, Alan Greenspan, exploited this idea, periodically using interest rates to push unemployment higher to achieve lasting reductions in inflation.
But even as they were doing so, the short-run impact of unemployment on inflation began to diminish. Though the trend has been under way for 25 years, only recently has intensive research by Fed economists and others incorporated it into mainstream thinking.
Well, I'm not sure how recent recently is, but my colleagues Terry Fitzgerald, Peter Rupert, and I wrote this in 1997:
A key aspect of [the conventional] perspective is the implicit, but critical, role of the potential-output and full-employment concepts in determining whether a particular growth rate or unemployment rate is inherently "inflationary." The meanings and implications of these concepts are the subject of considerable debate among economists. We are ourselves skeptical that there exists a definitive notion of labor market tightness associated with above-trend (or above-potential) real GDP growth that is reliably related to price pressures.
I don't present this to suggest that we were particularly prescient. As Dean notes, the conventional perspective is wrapped around the idea of the so-called NAIRU...
According to articles in both the Wall Street Journal and the Financial Times, the Fed may no longer view the non-accelerating inflation rate of unemployment (NAIRU) as a useful tool for guiding monetary policy. The problem seems to be that they don't know where it is and what it means.
... and, at the time we wrote those words above, many, many others shared skepticism about the usefulness of NAIRU-related concepts -- not least several members of the Federal Open Market Committee. From the transcript of the May 21, 1996 meeting of the FOMC:
CHAIRMAN GREENSPAN... The key to this outlook, as I see it, is not an evaluation of the physical side of the economy that appears in the Greenbook because I suspect that starting at midyear economic growth may well be on the low side of recent experience. The crucial question is the linkage to inflation. At this stage it is very difficult to take the existing structure of the NAIRUs, capacity limits, and the usual potential analysis that we do and square it in any measurable way with what we sense from anecdotal reports.
MR. JORDAN [Cleveland Fed]... Is your confidence in the 5-3/4 percent NAIRU instead of, say, 5-1/2 or 5-1/4 percent? Is it in the or 2-3/4 percent real fed funds rate versus 2-1/2 or 2-1/4 percent? Or is it in a particular measure of inflation or inflation expectations.
Mr. KOHN. I would have to say that I am not very confident about any of those measures. There is a band of uncertainty around them all. I do think that, as Mike Prell has commented--and I think Governor Meyer said this yesterday as well--there used to be more confidence about the NAIRU calculation.
CHAIRMAN GREENSPAN... The evidence that there is a significant shortfall in measured wages from the predictions of our wage-NAIRU econometric relationships is pretty clear.
VICE CHAIRMAN MCDONOUGH [New York Fed]... One of the things we have become rather convinced of is that the NAIRU is a very interesting analytical tool, but it is a very poor forecasting tool...
MR BOEHNE [Philadelphia Fed]... The NAIRU concept, while it means a lot to economists, is a very unfortunate way of communicating because 99.99 percent of the people do not understand it and it comes across as meaning that we are against growth and against more jobs.
MR. MCTEER [Dallas Fed]... There’s a sentence on page 6 of the Bluebook that says: “In the staff model, the sacrifice ratio over five years is about 2; that is, a 1 percentage point reduction in inflation can be achieved only by pushing the unemployment rate above the NAIRU by the equivalent of about 2 percentage points for one year.” At the end of 1996, in December, the CPI inflation rate was 3.3 percent, and I think the latest reading is 2.2 percent. It has come down then on that trailing basis more than a full percentage point at a time when the unemployment rate has come down by half a dozen notches...
MR. STERN [Minneapolis Fed]... if there is a NAIRU, it bounces around a lot.
MR. KOHN... In fact, we are very uncertain about the level of the NAIRU, and some of these supply shocks could be affecting it in a more permanent way.
You get the idea. I've cherry-picked the comments, but they accurately reflect my recollection of what was in the air at the time. In fact, to greater and lesser degrees, the reputation of the NAIRU way of thinking has been under attack for as long as I have been employed by the Federal Reserve System (starting in 1989). On the other hand, if you push most Fed folk about their view of how the world works, chances are very good that you will receive back a story about the NAIRU (or its close relations, the output gap and the natural rate of interest).
Remember the "New Economy"? File this story with that one.
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» Forget the NAIRU? from Economic Investigations
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Tracked on Feb 27, 2007 3:49:49 PM