Inflation Counterfactuals

Leading Market Monetarist Lars Christensen calculated the inflation rate for the U.S. if nominal GDP had grown 5 percent during the entire Great Moderation.    The growth rate of real GDP he assumes is from the CB0 estimate of potential output. He produced the following diagram:



He argues that this diagram shows that inflation was too high during the housing boom and too low during the Great Recession.    In my opinion, Christensen   makes the same error as Selgin.   While a 5 percent growth path for nominal GDP might be a good idea, the actual growth path during the Great Moderation was slightly higher.   While 5.4 percent might be only a bit higher, it makes a difference when trying to judge whether a past policy was inflationary.

I calculated P* which is the actual trend of nominal GDP from first quarter 1985 to the last quarter of 2007 divided by the CBO estimate of potential output.    The CBO estimates potential output for the next decade and the trend from the Great Moderation can be extended as well.

During the Great Moderation, the trend of P* is almost the exact same as actual trend for the GDP deflator.   It was about 2.4 percent.   (And the trend for real GDP was equal to the trend for the CBO estimate of potential GDP, both 3 percent.)

According to the CBO, potential potential began to grow for slowly in 2002, but this was from a level that had risen above trend during the Dot.Com boom.    Potential income fell below trend in 2005 and performed poorly since.  In no quarter was the estimate of potential income growth negative.   But during the depths of the Great Recession the growth rate fell to slightly below 1.5 percent, approximately half of the long run trend.    Potential income is 6.9 percent below its trend from the Great Moderation (and much longer.)     By 2022, the CBO projects the shortfall from the long run trend for the U.S. to be 14 percent.  (I think that is a more or less a disaster.)

The persistent reduction in the growth rate of potential income will result in higher inflation.   With the actual nominal GDP trend of 5.4, the level of inflation is higher, though the increase is the same.   The increase in the price level is substantial -- approximately 17 percent higher than with a 2 percent inflation rate target.   Again, if the CBO estimates are correct, then the inflation rate would above 3 percent in 2020.

Here is the estimated price level and the trend from the Great Moderation (which is the same as the actual trend of GDP deflator.)

Here is the estimated inflation rate and the trend from the Great Moderation:

If the CBO is correct, then nominal GDP level targeting, if more or less perfectly successful, would have resulted in inflation rising to nearly 4 percent from the 3rd quarter of 2009 to the first quarter of 2011.   According to their forecasts, inflation would only gradually slow down, though remain higher than the 2.4 percent trend of the Great Moderation for the next decade.

The more I do these calculations, the less faith I have in the CBO estimates.   Further, if there really is a productivity slowdown, then the proper solution isn't a slower growth rate of nominal GDP in order to keep inflation on target.   The solution is to fix the productivity slow down.   

Consider a world where wages and other money incomes continue to grow at trend, but slow productivity growth implies higher inflation.    Policy-oriented politicians claim that the problem is that we are having difficulty in producing goods.   That is why prices are going up.    The solution?   Come up with ways to increase efficiency.   Figure out ways for each worker to produce more.   Get inflation back down.

Consider another world.   The price level always grows at a stable rate.   When productivity slows down, wages and other money incomes must grow more slowly.    To actually get the wages to grow more slowly, the unemployment rate is high.   New entrants to the labor force have trouble finding jobs.   Firms have to adjust their compensation programs so that new workers start at lower pay and existing workers get fewer pay increases.    

Policy-oriented politicians say that the solution is to figure out ways to increase productivity.  Each worker needs to produce more.   How does that message play?     During the adjustment period when few new jobs are being created, getting existing workers to produce more appears to be in direct opposition to creating jobs for new workers.    It will lower inflation and then the central bank will adjust policy so more rapid nominal GDP growth will create more jobs?   Sounds like a tough sell.    

Several times recently I have accepted the RBC notion that if people choose to work less, then stable nominal GDP growth is undesirable.   Nominal wages and prices both rise.     It would seem desirable to instead let nominal GDP grow more slowly or even fall.    The wage rates could continue to grow on trend (or above trend because of an increase in labor-share of income,) while prices remain at trend.   Total wages would fall since people are choosing to work less.

However, there is a policy alternative.   For the U.S. anyway, increased immigration can offset any decrease in the desire of natives to work.   While this might not be terribly important in many circumstances, the problem of retiring baby-boomers makes it very important today.   As baby boomers retire, the growth rate of the labor force will tend to fall.   With nominal GDP level targeting, this will tend to force up money wage rates as well as prices.   

Now, we are seeing shortages of labor, rising wages, and rising prices.   Policy-oriented politicians propose that immigration restrictions be liberalized.    It so happens that taxes on the wages of the new immigrants will also support the medicare and social security expense of the baby boomers.    The immigration occurs during a time when there appears to be plenty of jobs--vacancies created by the retiring baby boomers.

On the other hand, suppose that an inflation targeting regime makes sure that nominal GDP grows more slowly and wages remain stable as baby boomers retire.   Because the bulge of retirees collects social security and medicare, severe budget problems develop.    A possible solution is to bring in more immigrants.   Policy-oriented politicians make that proposal.   But where are the jobs for all of these immigrants?   Is the answer to slow the growth rate of wages so employers will take them on?   Won't lower wages result in less social security and medicare taxes being collected?   Or is it that the slower growth of wages will result in inflation below target, and then the central bank will expand monetary policy enough to get nominal incomes growing.   Sounds like a hard sell.

For the U.S. during the next few decades, nominal GDP level targeting looks like a good idea.   If there is a productivity slow down or slow labor force growth, then those are the problems that need to be fixed.   Let price and wage inflation signal those problems.