‘Nobody thinks clearly, no matter what they pretend. … That’s why people hang on so tight to their beliefs and opinions; because, compared to the haphazard way they’re arrived at, even the goofiest opinion seems wonderfully clear, sane, and self-evident.’Dashiell Hammett, The Dain Curse (1928 , p. 181)
For a useful brief against production functions, see Felipe and Fisher (2003); for the case against capital aggregates, see Brown (1980). The idea that the inherent stability of the economy is a concomitant of general-equilibrium theory is difficult to entertain seriously after giving Fisher (1983) close study; see Grandmont (1982) for some related macroeconomic arguments. Finally, Hildenbrand (1994) provides a sobering corrective to first-year demand theory.
I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.
I will have nothing to say about what determines inflation expectations – either in principle, or in the context of the various survey and financial market measures that we can observe. (My hope is that any readers who finish this note will no longer find that question terribly interesting.)
In fairness, motivating a role for expected inflation was not really the original concern of these models; rather, their goal was to show that a nominal shock could yield persistent real effects under rational expectations. That said, I suspect that one reason why some (not all) economists reared on the Phelps–Friedman tradition were mostly willing to accept the New Keynesian Phillips curve was because the presence of an expected inflation term in the New Keynesian inflation equation resembled something that they already found reasonable when thinking about inflation dynamics.
Even if one does think that monetary neutrality is a feature of the real world, it would be an example of Aristotle’s 12th logical fallacy (affirming the consequent) to argue that the presence of monetary neutrality therefore necessarily implies a role for expected inflation in price or wage determination.
This flaw was recognized by Lucas and Rapping in their paper, which contains a lengthy (and strained) defense of the notion that this sort of price-level expectation formation is reasonable, along with an appeal to empirical evidence (that basically involves quoting Irving Fisher) to justify their imposed assumption that nominal interest rates would not move in such a way as to leave the real interest rate unchanged following an inflation change.
Similarly, models with wage contracts require workers to supply as much labor as is demanded at the contracted wage. Such assumptions violate the principle of voluntary exchange (and common sense).
Even New Keynesian models that explicitly incorporate time-varying trend inflation rates (usually to allow for the possibility of a change in the monetary authority’s inflation target) predict that short-run expectations of inflation will have an important influence on current inflation.
More recently, Clarida et al. (2000) have attempted to explain the sub-par macroeconomic outcomes of the late 1960s and 1970s by arguing that the Federal Reserve’s failure to adhere to the Taylor principle permitted self-fulfilling expectations of inflation – ‘sunspots’ – to influence macroeconomic outcomes, while also leaving the economy more susceptible to ‘fundamental’ shocks. However even if the Federal Reserve’s policy reaction function did have this property – a view that has been questioned by Orphanides (2004) and by Sims and Zha (2006), among others – the Clarida et al. interpretation of the 1970s stagflation requires that period’s food and energy price shocks to have resulted in a large and rapid decline in the level of potential output. (Had non-fundamental inflation shocks been the source of the Great Stagflation, output would have been above potential throughout this period.) Such a decline in potential seems highly unlikely in the case of a food-price shock; in addition, as Blinder and Rudd (2013) discuss, Neoclassical supply theory predicts that the effect on potential output from a shock to energy prices (or other imported commodity prices) is relatively small.
Empirically, this unit sum became easy to find around the mid 1970s – see Gordon (1976) for a contemporaneous account, and McCallum (1994) for a retrospective one. It should also be noted, however, that King and Watson argued as late as 1994 (see King and Watson 1994a) that it was surprisingly difficult to reject the hypothesis of no long-run trade-off in US data without simply imposing it through the ‘Monetarist’ assumption that ‘long-run inflation is a strictly monetary phenomenon’ (King and Watson 1994b, p. 245), though see Evans (1994) for an alternative view.
Several other studies from the 1970s and 1980s tried to use survey-based or commercial inflation forecasts to disentangle the separate roles of ‘inertia’ and ‘expectations’ in union wage-setting; see Kaufman and Woglom (1984) for one example as well as for a useful literature review. (As one might expect from the vantage of hindsight, the Kaufman–Woglom paper found ‘surprisingly small’ differences between specifications that used ‘direct’ expectations measures and specifications that simply used lagged actual inflation.)
See Rudd and Whelan (2006) for a discussion of the latter point in the context of a ‘hybrid’ New Keynesian Phillips curve. The dependence on far-future events arises in the ‘pure’ New Keynesian Phillips curve when a unit coefficient on
is imposed because each expected future output-gap term in the closed-form solution makes the same contribution to current inflation; alternatively, a role for sunspots arises because the terminal inflation term in the closed form never vanishes.
See Rudd and Whelan (2005) for a discussion of the misspecification issue. The weak identification issue affects the hybrid New Keynesian Phillips curve (and was one of several motivations for the alternative tests of the model that Rudd and Whelan 2006 considered); it arises because the variables that are used to instrument for expected future inflation
will only be able to tie down the influence of this term if a large portion of the predictable variation in inflation is unrelated to lagged inflation. (See Mavroeidis et al. 2014 for a detailed discussion of the estimation issues that arise as a result.)
These estimates are obtained from vector autoregression (VAR) models with time-varying parameters and stochastic volatility, and are taken from Peneva (2019); see Peneva and Rudd (2017) for a detailed discussion of the estimation procedure and data. Impulse responses for labor costs – also found in Peneva (2019) – imply a much greater degree of stability for the wage Phillips curve (a finding that is also obtained using conventional empirical wage equations).
The integral multipliers are defined as the ratio of the cumulated n-quarter impulse response of price inflation to the cumulated n-quarter response of the unemployment gap. Calculations such as these are useful because they account for any time variation in the response of the unemployment gap.
The characterization of inflation dynamics implied by the flattening of the price Phillips curve and the near-constancy of inflation’s long-run trend imply an explanation for the so-called ‘missing disinflation’ of the late 2000s that is drastically different – but much more plausible – than the one advanced by Coibion and Gorodnichenko (2015). In particular, that study starts from a price Phillips curve that imposes a unit coefficient on lagged inflation (or on a measure of short-run expected inflation that is closely related to lagged inflation). As a result, the inflation equation that they use, which is essentially an accelerationist Phillips curve, ignores the empirical fact that inflation essentially became a mean-reverting process after the mid 1990s. As Peneva and Rudd (2017, p. 1798) note, such a model of inflation ‘generates a misleading benchmark for how we would have expected inflation to behave following the 2007 business cycle peak.’
More precisely, the measure shown is for ‘trend’ unit labor cost growth, which uses a measure of trend productivity growth (obtained separately with a bandpass filter) in lieu of actual productivity growth – see the data appendix of Peneva and Rudd (2017) for details. Hence, the line in the figure is the stochastic trend for trend unit labor cost growth.
We can make a reasonable case that reactions of labor costs to actual inflation were an important feature of the inflation process in the 1970s. In particular, without this channel’s being present, it is nearly impossible to explain why movements in food prices left a durable imprint on core inflation – unlike energy, which can plausibly be viewed as a broader input to industry, changes in agricultural prices shouldn’t act like a cost shock to firms outside the food sector.
On the other hand, perhaps people actually do expect (say) that a period of 3 percent inflation will be followed by a corresponding interval of 1 percent inflation, leaving the five-to-ten-year average around 2 percent. But I doubt it.
Similarly, firms might also still be very concerned with their costs, but a relatively small portion of these costs will co-move with economy-wide inflation (beyond those induced by changes in import prices) given that wages are not closely tied to actual inflation and given that – with the exception of labor and imports – one firm’s input-cost increase is another firm’s output-price increase.
This study also finds that contracts concluding in 1974 that did not contain explicit escalation clauses tended to see larger average wage increases over the contract period than did contracts with escalation provisions, and notes that this evidence might be consistent with the idea that anticipated inflation – that is, short-run inflation expectations – might have started to enter into wage contracting around this time. However this evidence is also consistent with the notion that the lack of an explicit escalator provision would introduce an insurance motive into wage agreements; most likely, it reflects the fact that explicit escalator clauses contained caps or other provisions such that only about half of a given increase in the CPI tended to show up as a cost-of-living adjustment.
The relationship between consumer sentiment and inflation is a well-known and long-established stylized fact among consumption forecasters, as is the relationship between sentiment and measures of real activity and household wealth. (Of some possible interest for thinking about wage determination, there does not appear to be an economically or statistically significant relationship between changes in the quit rate and changes in inflation over the past 20 years.)
What these facts seem to be inconsistent with, however, is an explanation based on strict rational inattention: in a standard model of that sort, agents who did not consider information about inflation to be important would simply ignore it completely; by contrast, once they paid attention to it in one context (sentiment), there would be no reason to ignore it in another sphere (employment) unless they found it significantly more difficult to understand or ‘process’ the implications of changes in inflation in the latter context. It should also be pointed out that the justification given here for the presence of long-run expected inflation in the Phillips curve can’t say anything about another important observed change to the inflation process – namely, why the price Phillips curve has flattened over time even though the wage Phillips curve has not.
As noted, movements in measures of expected inflation – which even today can be relatively large and persistent – do not appear to contain much (or any) information about inflation’s stochastic trend.
Even if a policymaker’s target for actual inflation is informed by a carefully determined ‘optimal’ level of inflation, it seems plausible that the loss to policymakers from having actual inflation persistently average slightly above or below that target would be smaller than the loss that would obtain (from an overall stabilization standpoint) by having inflation behave in a more persistent, ‘accelerationist’ manner.
Likewise, the single observation that we have suggests that returning to a regime where trend inflation is once again invariant to the state of the economy would be difficult and costly: even the Volcker disinflation wasn’t able to achieve this outcome, since inflation’s long-run trend persistently moved lower once again after the 1990–1991 recession.
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