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%.