The NAIRU Tailor-Made for the Fed? By Kevin L. Kliesen

ccording to a recent editorial thought it should be, then they could Apublished in The Wall Street reliably boost —by Journal, Federal Reserve monetary increasing the growth of the money policy relies inordinately upon a supply—without causing concept known as NAIRU—the to accelerate. But as Nobel Prize - Non-Accelerating Inflation Rate winning economist Milton of . According to Friedman warned in 1967, the June 15 editorial: efforts to lower the unem- "... there are signs the Federal ployment rate through Reserve is worrying about inflation aggressive monetary expan- for the wrong reasons. While mod- sion would eventually result in ern markets keep trying to move on a higher inflation rate only. to the 21st century, the Fed won't let Friedman was later proven go of such hand-cranked notions as correct, as both inflation and the , or NAIRU—a unemployment rose simulta- concept as dense as its name." neously during the 1970s. poten- Although the monetary In the hopes of salvaging tial GDP, and authorities regularly use models something of the framework, Phillips a positive output gap opens up. based on a NAIRU/Phillips curve curve proponents devised two impor- When this happens, upward pressure framework—that is, to forecast tant innovations. First, that expecta- on wages results, which is then trans- inflation, which figures promi- tions matter: Specifically, that the mitted into higher prices for goods and nently in deci- current level of inflation is importantly services. This does not occur immedi- sions—do they rely upon them influenced by firms' and individuals' ately, however, since price changes at to the degree that some believe? expectation of future inflation rates. the individual firm (micro) level take Second, the original measure of aggre- time to work their way into price gate demand—the civilian unemploy- changes at the aggregate (macro) level. The Phillips Curve: Whole Cloth ment rate—was replaced by something The accompanying chart, which or Hair Suit? called the output gap. The output gap is includes all combinations of the the difference between measured real (lagged) U.S. output gap and the infla- The modern Phillips curve has GDP and the (estimated) level of real tion rate from 1960 to 1998, shows how evolved into a catch-all term that GDP that could exist based on the the Phillips curve has evolved over describes the causality between economy's available amount of capital time.4 From 1960 to 1969, just as pro- changes in the aggregate price and labor inputs, and on how produc- ponents believed, the Phillips curve dis- level (inflation) and the strength tive those inputs are. This is where played a positive slope: The more real of aggregate demand. Although NAIRU enters the picture. GDP rose above potential GDP, the fur- the curve has had a controversial ther the reported unemployment rate history in the profes- fell below NAIRU, and, thus, the more sion, it nonetheless underpins the Inflation, the Output Gap and NAIRU inflation rose. During the 1970s and short-term inflation process of 1980s, though, as indicated by the pro- most large-scale macroeconomic Many of those in the business of gressively flatter slope of the line, the 1 forecasting models. The relation- forecasting inflation rates—for example, relationship began to break down. ship is named for New Zealand the Board of Governors—use large- During the 1990s, the relationship economist A.W. Phillips, who scale macroeconometric models based between NAIRU and inflation disap- showed how the unemployment on a Phillips curve framework. The peared, and the Phillips curve became a rate varied inversely with the rate basic premise behind the modern virtually flat line. Not only that, but if of change in nominal wages in Phillips curve is that this year's inflation the observations for 1990 and 1991— the United Kingdom from 1861 rate is, to a large extent, determined by years of relatively high inflation and to 1957. Unlike Phillips'original last year's output gap. So, how does unemployment—were removed, the framework, the modern Phillips NAIRU enter the analysis? NAIRU is slope would be negative.5 curve now alleges an inverse the unemployment rate that would Phillips curve proponents argue that trade-off between the unemploy- result when the output gap is zero; that a series of favorable supply shocks has 2 ment rate and inflation. is, when the economy is growing at its temporarily distorted the unemploy- Initially, some economists potential with no unusual wage and ment rate/inflation nexus.6 These believed that a stable relationship price pressures/ But. when aggregate include the dramatic reduction in health existed between unemployment demand growth is such that the care costs between 1993-95 and the and inflation. In other words, if demand for labor temporarily pushes plunge in crude oil prices between late the unemployment rate was the unemployment rate below NAIRU, 1996 and late 1998. Phillips curve pro- higher than what policy-makers measured real GDP is greater than ponents argue that, once these factors

[10] The Regional Economist • October 1999

are accounted for, the relationship still was still a negative output gap (actual holds. Others, however, argue that, unemployment was above NAIRU) in ENDNOTES 1 Most economists believe that, in unless these factors can be identified early 1994, the FOMC, in what would the long run, there is no trade-off beforehand, the Phillips curve relationship become known as the "pre-emptive between inflation and unemploy- cannot be reliably exploited by the cen- strike against inflation," pushed the fed ment. In other words, over time, 7 the average unemployment rate, tral bank to forecast inflation. funds rate target back up to 6 percent or natural rate, is determined by microeconomic factors like union- by February 1995. Moreover, although ization rates or minimum wage Is the Fed in a NAIRU Straitjacket? the unemployment rate has persisted laws. Likewise, over the long haul, well below NAIRU since May 1995, the most economists also believe that inflation is determined principally With an uncertain—if any—trade-off FOMC has moved to increase the fed by the amount of money created between inflation and the output gap in funds rate three times since then (in by the central bank. the 1990s, monetary policy-makers have March 1997, June 1999 and August 2 The leap from changes in wage rates appeared to change their view of the to the inflation rate was assumed 1999). In fact, because of the Asian cri- to occur by some sort of mark-up inflation process, and reacted accordingly. sis and Russian debt default last year, process—that is, employers passed Since August there have been along higher wage costs to their customers. Humphrey (1986) is 1987, the FOMC twice as many an excellent reference on how the raised or lowered The Modern Phillips Curve reductions than Phillips curve evolved over time. the federal funds increases in the 3 NAIRU is not the same as Friedman's rate target 49 natural rate of unemployment. What Worked in the '60s and 70s... funds rate over NAIRU stresses the hypothesized times, with this period. short-term relationship between decreases in the In short, dur- inflation and the unemployment rate. Friedman's rate, as noted in target outnum- ing the past four Footnote 1, is the rate that would bering increases years or so it occur over the long run. 30 to 19. If the appears that 4 This specification follows the one FOMC relies FOMC policy- hypothesized by Stanford Professor heavily on John Taylor. makers have— 5 The chart shows how the expected Phillips curve more often than inflation rate has changed over inflation fore- time. This is seen as the point not—ignored the where the Phillips curve intersects casts, then more policy prescrip- the vertical line: Since the early increases in the tions of the mod- 1980s, the Phillips curve has steadily shifted back down from where it fed funds rate ern Phillips curve. was during the 1970s. should be seen This should not 6 See Meyer (1999). when the actual be too surprising 7 See Rasche (1998) and the Winter monthly unem- 1997 edition of The Journal of Looks Broken down in the '80s and '90s given the poor ployment rate performance of Economic Perspectives. falls below most forecasting NAIRU—or, models during FOR FURTHER READING Humphrey, Thomas M. From Trade- equivalently, this period. So, offs to Policy Ineffectiveness: when the output what have policy- A History of the Phillips Curve. gap is positive. makers been Federal Reserve Bank of Similarly, when Richmond (October 1986). looking at when Meyer, Laurence H. "The Global the unemploy- forecasting infla- Economic Outlook and Challenges ment rate rises tion? There is Facing Monetary Policy Around the World," Remarks at the Annual above NAIRU (a some evidence Dinner of the Society of Business negative output that they have Economists, London, England, gap), we would paid more atten- February 25,1999. expect to see the Phillips, A.W. "The Relation between tion to expecta- Unemployment and the Rate of FOMC moving tions. That is, if Change of Money Wage Rates in to lower the fed the United Kingdom, 1861-1957," NOTE: The inflation rate is calculated from the markets expect Economica (November 1958), funds target rate. PCE chain-type index. inflation to pp. 283-99. In the late The charts show the relationship between inflation remain low for Rasche, Robert H. "Money and Real 1980s and early and the output gap for each of the last four decades the foreseeable Output," in Money, Prices and the 1990s, this was (the Phillips Curve). Since the early 1980s, the Phil- Real Economy, Geoffrey Wood, ed. lips Curve has shifted back to where it was during future, and expec- (Northampton, MA: Edward Elgar, generally the the 1960s. It has also become flatter. This means tations matter 1998). case. From that expected inflation has returned to its '60s level, more than the Symposium on the Natural Rate of and that the Phillips Curve trade-off has become Unemployment. The Journal of March 1988 to much weaker. output gap, as Economic Perspectives (Winter 1997), February 1989, some believe, then pp. 3-108. for instance, with policy-makers will strong economic growth pushing the be less likely to view a low unemploy- unemployment rate below NAIRU, the ment rate with the alarm that they have FOMC raised the fed funds target rate in the past. Either way, using the Phillips from 6.75 percent to 9 percent. But as the curve framework to forecast inflation, economy began to slow, eventually enter- and thus potential FOMC policy moves, ing into a recession in July 1990, the is a process fraught with difficulty. FOMC reversed course, eventually reducing the target rate to 3 percent in Kevin L. Kliesen is an economist at the Federal September 1992, which is where it stayed Reserve Bank of St. Louis. Thomas A. Pollmann until February 1994. Even though there and Daniel R. Steiner provided research assistance.

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