The Fed understands stagflation

Published by Skeptikos on Sep 26, 2016

Disagreeing with Janet Yellen, who’s built a formidable forecasting record, is always risky. The chance of catching basic errors are slim.

So it’s easy to guess that Jeff Spross’ opinion piece in The Week titled “The Federal Reserve is irrationally obsessed with the 1970s” gets it wrong. Spross argues:

Many Fed policymakers, including doves like Chair Janet Yellen, believe that once the inflation rate gets going, it's like a runaway train — nearly impossible to stop and demolishing everything in its path. But there's just one problem. This belief is based on just one badly misunderstood historical example in the United States.

And how is this example badly misunderstood?:

First off, there was a screw-up in the consumer price index (CPI) — probably the most widely used measure of inflation. By the late 1970s, it was overstating the inflation rate by about 2 percentage points — which is a lot. That's important because unions, which were still pretty strong in the 1970s, had enforced automatic cost-of-living adjustments (COLAs) in a lot of workers' contracts. Those adjustments relied on the CPI, which created a perverse ratchet effect: As inflation rose, employers had to compensate with pay hikes that overstated inflation. Then prices had to increase to pay for those wages, leading to further inflation.

Whooaaa, let’s slow down and think that through. We’re talking about 2 percentage points, which actually isn’t a lot. We can demonstrate this with a simple example. Let’s say half of workers get automatic cost of living adjustments based on the CPI. (This is being generous. I’m having trouble tracking down the real number, but it’s certainly lower than half.) And let’s say 70% of production costs are wages. (This is a real number.) Let’s also make some simplifying assumptions about the economy: no worker with COLAs gets fired, firms are perfectly competitive, and consumers don’t change what they buy in response to the changing prices. Every single one of these assumptions is wrong in real life, and every single one will make our simple estimate higher than it should be. We are being extremely generous in favor of the COLA ratcheting hypothesis. Now, having made all these simplifying assumptions, when half of workers get their wages raised an extra 2%, we can calculate the amount added to prices:

raised wages + unraised wages + capital costs = 0.7 × 0.5 × 1.02 + 0.7 × 0.5 + 0.3 = 1.007

The extra wages lead to extra inflation of 0.7% per year. Over a period of 3 years this might lead to 2.1% higher inflation. If only a quarter of workers got COLAs based on the CPI, then the estimate goes down to 1% over 3 years. Even under the most generous assumptions, this is a small ratchet compared to the 14% inflation at the end of the 1970’s.

Alright, so this one is a foul ball. What’s next?

Another issue was the price of oil. The Organization of Petroleum Exporting Countries (OPEC) launched an oil embargo between 1973 and 1974. Then the government of Iran, one of the world's biggest oil producers, was overthrown in 1979. As a result of both events, oil prices rocketed into the stratosphere during the 1970s. Since oil is a fundamental expense in so much economic activity — commuting, shipping, even chemical engineering — those price jumps rippled into prices throughout the economy. It's a temporary effect, but it matters.

Economists definitely do not “badly misunderstand” oil prices during the 1970’s-- oil plays a leading role in economists’ traditional stagflation lore. Alan Blinder’s book Hard Heads, Soft Hearts has an excellent treatment of this subject. Strike.

Third, labor markets in the 1970s were actually pretty tight, at least early on. Labor force participation wasn't down — in fact, it was rising due to the advent of the female workforce. So even though unemployment got uncomfortably high after the recessions in 1970 and 1974, wage growth ranged from 5 to 8 percent, often staying well ahead of the rising inflation rate. Those are signs employers are competing for workers, rather than workers competing for jobs.

It’s possible that the labor market was tight in the early 70s, though I’m not convinced by this argument. After the short recession of 1970, I doubt the labor market was any tighter than it is right now. Actually, the situation looks like something that could happen today: interest rates were low to spur recovery from the recent recession, the economy picked up and grew rapidly, generating inflation, the Fed starts to cut back and then the first oil price shock hits and things go downhill from there. We’re missing the oil shock piece but that’s it. Another foul ball.

One more:

Tight labor markets are nowhere in sight: Despite the 4.9 percent unemployment rate, labor market participation is still deeply depressed thanks to the aftermath of the Great Recession. Nominal wage growth is at a mere 2.5 percent, compared to the 4 percent we saw in the economic boomlet of the late 1990s.

This is a controversial statement. If you think a big part of drop in the labor force participation rate (that is, the percent of Americans actively looking for work) is due to the recession, then this statement is correct. If not, then it’s false. In reality we don’t know. Or at least I don’t know, and I’ve been following macroeconomic debates since 2008.

Regardless of labor force participation, 4.9 percent unemployment is low. It’s completely possible that full employment is right around the corner. Due to the lags in our measurements, we could even be at full employment already and just not know it yet. (OK, probably not. But the possibility is there.) When we hit full employment, inflation will start increasing, and raising rates by a small amount could be prudent if there are signs we’re nearing that point.

But let’s put this back into perspective. We’re talking about interest rate increases of 1%, or even 0.25%. The Fed is only experimenting with the fine-tuning knob on the economy right now. If we’re going to have a recession, or a recovery, a 1% higher interest rate isn’t going to matter much. I don’t understand how people get worked up about this.

I think Spross hit the ball at some point in the argument, but I don’t know because I fell asleep. Wake me up when the Fed starts talking about 5% interest rates.