Econintersect: Robert E. Hall, Hoover Institution and Department of Economics, Stanford University, presented a paper Friday at Jackson Hole. In analyzing the extraordinary monetary actions of the Fed in response to the Great Financial Crisis, Hall discusses the relationships between employment and inflation and the interaction with expansionary monetary policy such as has been practiced by many central banks over the past five years. Econintersect finds this an excellent and very readable paper, but does find some areas where additional future work is indicated.
Hall spends the early part of the paper discussing the relationship between inflation and employment:
Since the birth of the Phillips curve in the 1950s, the idea has dazzled macroeconomists that inflation depends on tightness or slack. Yet extreme slack has done little to reduce inflation over the past 5 years (fortunately!) and extreme tightness in the late 1990s did not result in much inflation.
Hall is referring to the work of A. W. H. Phillips, an electrical engineer who turned to sociology and then became an economist at the London School of Economics. Phillips studied the relationship between employment and inflation between 1861 and 1957 in the UK and found a consistent relationship as shown in the caption graphic above (from David Sims).
This was his most widely recognized piece of work, although some have maintained it was his least well founded (eg, Charles Holt, Steve Keen, among others). Hall thoroughly discusses the evolution of the Phillips Curve analysis and interpretation over the last 50 years. The next paragraphs present some large pictorial supplement to Hall’s excellent discussion.
Phillips looked at the data over three eras: 1861-1913, 1913-1948 and 1948-1957. Economists were delighted when the first out-of-sample period in the 1960s continued to show the expected functional behavior (Kevin Hoover):
This was more than 100 years of empirical evidence – what relationship could be more solid?
Well, over the past 43 years the sand has shifted under the “solid” Phillips curve structure.
One of the better examples of shortcomings of the Phillips Curve hypothesis was presented by Robert J. Gordon in 2009:
Click on graph for larger image.
Econintersect has annotated the Gordon graph indicating a possible area for straight line regression fits of the data.
Click on graph for larger image.
Obviously this Phillips curve plot yields no Phillips curve.
And things look similar when the data from 1948-2000 is plotted (from Macroeconomic Challenges):
.JPG)
There are periods of a few years where the classical negatively sloped Phillips curve can be seen and others where the positively slope “anti-Phillips” curve is displayed. And there are times when the pattern could be displayed in a Christian Church: See 1953-54-55-56-57.
Moving on to the broader discussion from Hall’s paper, the shortcomings of reliance on the Phillips curve is recognized as he discusses the broader issues of monetary policy and economic response.
One of the observations that Hall makes regards the failure and the success of the extended extraordinary easing of the Fed:
The Fed responded aggressively to the events of 2008, ending the year at a zero policy rate. Other central banks followed suit, though not with the same determination. But far from relieving the interest bound, the policy failed to prevent a decline in inflation, a decline that has worsened recently. Fortunately the decline was modest, quite unlike the extreme deflation of 1929 to 1933, which raised the real rate to catastrophic levels.
Hall draws one conclusion early in the paper (page 4):
The obvious conclusion from these observations is that raising prices and wages faster than normal is not a market outcome in a tight economy and raising them slower or even allowing them to fall is not a market outcome in a slack economy. The natural basis for that situation is that markets are in equilibrium, sometimes tight and sometimes slack, but in equilibrium in the sense that no actor believes that changing price- or quantity-related behavior would be privately advantageous.
So the analysis falls back to the assumption that the behavior observed is due to equilibrium among the variables observed and no variation among “actors” exists. Modeling multivariate complex functions using “representative agents” or “actors” has been criticized as presenting an unrealistic simplification: representing macro conditions with micro parameters. Such modeling risks missing significant (even dominant?) effects from the very large number of possible interactions between micro entities.
Editorial comment: In addition, why is it not more likely that other factors not included in the analysis are varying and the dynamic result is what is mistakenly observed to be an equilibrium for the variables that are measured? Econintersect would suggest that this is a very real possibility and a much more extensive analysis is necessary to include or dismiss other dynamic variables impacting the observations. Hall repeatedly attributes things that appear stable (slowly changing) to be “in equilibrium” and to consider rapid changes to be “shocks” that disturb equilibrium. This is a major shortcoming of the paper which otherwise makes a number of meaningful observations. But the meaning of this work could be much greater if economic variables were modeled as multivariate complex functions (recognizing extensive cross-element interactions) with all independent variables time variant functions.
Here is the abstract of Hall’s paper:
The United States and most other advanced countries are closing on five years of flat-out expansionary monetary policy that has failed in all cases to restore normal conditions of employment and output. These countries have been in liquidity traps, where monetary policies that normally expand the economy by enlarging the monetary base are ineff ectual. Reserves have become near-perfect substitutes for government debt, so open-market policies of funding purchases of debt with reserves have essentially no effect. The U.S. economy entered this state because a financial crisis originating in a financial system built largely on real-estate claims came close to collapse when the underlying assets lost value. Rising risk premiums discouraged investments in plant, equipment, and new hiring. Weakened banks and declining collateral values depressed lending to households and forced their deleveraging. The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level. As output demand recovers, the lower bound will cease to be an impediment and normal conditions will prevail again.
Sources:
- The Routes into and out of the Zero Lower Bound (Robert E. Hall, Jackson Hole Conference, 23 August 2013)
- Why Inflation Could Give the Economy a Boost (David Sims, Seeking Alpha, 05 July 2012)
- Phillips in Retrospect (David Laidler, Review of book by Robert Leeson on the collected works of A.W.H. Phillips)
- Phillips Curve (Kevin D. Hoover, The Concise Encyclopedia of Economics, Library of Economics and Liberty)
- The History of the Phillips Curve: Consensus and Bifurcation (Robert J. Gordon, NBER Working Paper, 07 March 2009)
- The Phillips Curve (Macroeconomic Challenges)
