PSA: Brief but Substantial Inflation is Expected in a Recovery

I
I've been thinking on the Kocherlakota turn-around and the recent hubbub over the increased TIPS spread, and I'd like to say a piece on inflation in recoveries.

My outlook on inflation in recoveries is informed mostly by John Maynard Keynes in his General Theory of Employment Interest and Money. In one of the final chapters Keynes lays out dynamics of the price level in a slump and in a recovery with regard to the price-output split. Basically, as aggregate demand increases, some of that demand manifests itself as more real output and some as inflation; the amount of each is determined by the slope of the short-run aggregate supply curve. If all workers and capital goods were perfectly fungible, no factors of production would be in a position to demand higher nominal compensation while some resources were still idle. So any increase in nominal demand would be met purely with an increase in real GDP while real GDP was below its potential. Once real GDP was at its potential, however, any increase in demand would merely add more inflation with no increase in output. No inflation while the economy is depressed, soley inflation once the economy is recovered.

In reality, however, workers and capital goods are far from perfectly fungible. This means that as aggregate demand increases, some factors of production find themselves fully employed before others and before real GDP is at its potential, so that they can demand higher rates of remuneration while the economy recovers but before it has fully. So in a normal recovery, we should expect to see a spurt of increased inflation as employment and prodction recovers, and for this inflation to tapper off once recovery has been achieved. There is no long-tradeoff between inflation and unemployment; but the two should reverse correlate during a healthy recovery.

Note how inflation rises and falls with the utilization rate of manufacturing capacity; the price level is determined by aggregate demand AND supply. 

Teams with Plans, not Men with Cred

As with any presidential election, the decision between President Obama and Mitt Romney ultimately comes down not to which man is more suited to the office but to what team they will bring in to conduct policy. And the spoils of the general election go to the candidate who convinces the American electorate that their team will deliver them the goods. Obama's message in 2008 that he would make Americans richer with infastructure spending, education support and more progressive taxation trumped John McCain's attempt to run on his military and service credentials. In 2000, Bush's calls to redistribute the budget surplus in the form of tax cuts overcame Gore's message of... okay, bad example.

Americans in 2012 must evaluate the different promises made by the Obama and Romney team, not just the personal gravitas or experience each man may or may not have. We have a rather clear idea of what Obama's plan will entail; thats the benefit of being the incumbant. We can expect continued investments in public infrastructure, an open but cautious stance toward international trade, and perhaps increased spending on scientific research and subsidies for new engery industries. If Obama moves on taxes at all, we can expect him to allow the Bush tax cuts to expire, which would boost top marginal rates slightly. As far as the Federal Reserve, Bernanke and Co. are likely to stay in place, and that crowd seems to be moving in the direction of NGDP targeting, or at least likely to remain sympathetic to accomodative monetary policy as labor and capital markets stay slack. 

We have to distill Team Romney's plan from what he has claimed on the campaign trail, the history of his running mate's plans, and the opinions of his closest economic advisors. From that, we can predict reduced spending on infrastructure, reduced spending on scientific research and alternative energy subsidies, and a combative stance on international trade. In tandem, Romney would slash taxes by reducing capital taxes and marginal tax rates across the spectrum. As far as monetary policy, its widley expected that Romney would replace Bernanke with advisor John Taylor at the first chance. This would mean a change in the stance of monetary policy away from NGDP targeting and expansion and toward a tightening intended to raise the Fed funds rate to the level determined by Taylor's own Taylor Rule. 

As a caveat applied to both teams, I highly doubt either approach will be successful in closing the long-term budget deficit. I say that because despite the posturing, neither side has given a comprehensive or coherent plan for dealing with the driver of those deficits, Medicare.

Has Obama Made Us Better Off?

Not according to Mitt Romney. But the facts claim other wise. Let's take a look at some charts of key indicators to distill the President's real economic record: In order of appearence, we have unemployment, real GDP, capacity utilization in manufacturing, and the S & P index.

So we have lower unemployment, more national income, less idle manufacturing capacity, and a substantially healither stock market. And that doesn't count as being better off? I suppose the facts really are stubborn things; but who needs the facts when you've already got the answers?

Kocherlakota may be a Dove, But he Needs to Read his Milton Friedman

So Narayana Kocherlakota, one of the perennial hawks on the FOMC, has revealed himself to be a dove. 

"The new “liftoff plan,” Kocherlakota said, was an alternative to the proposal from Charles Evans, president of the Chicago Fed Bank, in which the central bank would commit to keeping rates exceptionally low until unemployment falls below 7%, only stopping if inflation rises to 3%."

I would add one large adjustment. Basically, it comes down to a question of derivatives. Kocherlakota is advocating using the derivative of the price level as an indicator. He needs to monitor the second derivative of the price level. 

What this means is that instead of an increase in prices, the Fed should watch for an acceleration in prices. This harkens back to the original work on the Philips Curve by Milton Friedman in his 1967 speech to the AEA. Friedman dissproved that there is a long-run tradeoff between inflation and unemployment, despite the statistical appearance of a short-run trade-off.

His reasoning went as follows: as inflation rises, final product prices rise faster than nominal wages which take longer to adjust due to labor contracts. This rise in P relative to W (the nominal wage) leads to a lower real wage or (W/P). The structure of real wages is now lower than the equilbirum value that clears the labor market, creating an excess demand for labor. This leads to faster job growth as employers try to soak up "cheap" labor, and this creates the short-run Philips Curve illusion.

The buck does not stop there, however; workers find that their nominal wages do not command the purchasing power they did now that inflation has caused the price level to rise. So nominal wage contracts are renegotiated upward, so as to return real wages to their equilibrium value. 

Central banks, therefore, can only lower unemployment below the "full employment" level of unemployment if they continually increase the rate of money growth, not merely create a high rate of growth. Final product prices need to rise faster than workers can anticipate, so as to keep real wages below equilibrium and create the excess demand for labor. 

What this means for Kocherlakota is that a high rate of inflation, if it stabilizes, does not indicate that labor markets are in equilibrium. Accelerating inflation, however, is the inicator that labor markets have cleared, and further additions to aggregate employment will only persist as long as the Fed can fool workers.

In short, here's my prediction: Kocherlakota's 5.5% unemployment target will only be met if inflation is permitted to rise above 3%. 

Video Time: A Very European Break Up

Interest Rates and Monetary Policy (part 1, of many)

With the Fed's resumption of the task of trying to do it's job, I figured I'd get around to a piece on interest rates and monetary policy I've been putting off for a while. Here goes.

The interest rate is a price like any other; it is the price of present consumption in terms of future consumption.  Say you start out with $200. You have the option of consuming the entire $200 today, or delaying consumption until a later date in order to consume more. The tradeoff is given by the equation:

Future Value of consumption  = Present Value of consumption * (1 + r) ^ t  where r is the real interest rate and t is the amount of time consumption is delayed. So $200 delayed at a real interest rate of 5% for 10 years would be: $200 * (1+0.05) ^ 10 = $325.78. The higher the interest rate and the longer the time defered, the greater the consumption to be had in the future. 

The point of this is that the real interest rate is an actual price, the kind settled by good ol' fashion supply-and demand, where supply and demand are the supply of deferred consumption and the demand for purchasing power immediately, as illuistrated by the following diagram to the right. 

The tradeoff  between consumption today and consumption tomorrow can be illustrated by the indifference curve to the left. Any point on the curve represents a combination of present and future consumption that maximizes utility for the individual, with the actual combination being point where the curve intersects the budget line.

Who Owns the Income Now?

Something I've been curious about for awhile; you here a lot about income inequality, but rarely about where the income is located geographically; here's the answer.

On the subject of economic geography, check out this old paper by Paul Krugman on the subject.

and the same map, for 2008

Also, here's unemployment by county.