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Tuesday, July 27, 2010

Fed Watch: Rising NAIRU?

Policymakers should be more concerned about the possibility of rising long-term unemployment:

Rising NAIRU?, by Tim Duy: Brad DeLong reads Greg Mankiw and reaches the conclusion that:

Mankiw's broader point is that since we have seen nothing like this before except for the Great Depression, we should be humble and risk averse--and hence have the government stand back and wash its hands of the situation.

Paul Krugman concurs, adding a sense of urgency to the current situation:

Quite. I really don’t think people appreciate the huge dangers posed by a weak response to 9 1/2 percent unemployment, and the highest rate of long-term unemployment ever recorded…

...Right now, I’m reading Larry Ball on hysteresis in unemployment (pdf) — the tendency of high unemployment to become permanent. Ball provides compelling evidence that weak policy responses to high unemployment tend to raise the level of structural unemployment, so that inflation tends to rise at much higher unemployment rates than before. And the kind of unemployment we’re experiencing now, with many workers jobless for very long periods, is precisely the kind of unemployment likely to leave workers permanently unemployable.

And there are already indications that this is happening. Bill Dickens, one of the people has who worked on downward nominal rigidity, tells me that the Beveridge curve — the relationship between job vacancies and the unemployment rate — already seems to have shifted out dramatically. This has, in the past, been a sign of a major worsening in the NAIRU, the non-accelerating-inflation rate of unemployment.

Mankiw said something eerily familiar recently:

This recession looks very different, and much more troubling, than those in the recent past. I wonder how this dramatic change in the nature of unemployment will alter traditional macroeconomic relationships, such as Okun's Law and the Phillips curve.

Some research suggests that the long-term unemployed put less downward pressure on inflation. If that is indeed the case, then the increase in long-term unemployment may mean that we will see less deflationary pressure than we might have expected from the high rate of unemployment. In other words, the NAIRU may have risen, perhaps quite substantially. This is mostly conjecture, however. It seems likely we will see more work on this topic in the coming years.

So Mankiw recognizes the problems posed by protracted periods of economic weakness, yet in his criticism appears to push for more caution while overlooking an obvious reason why the impact of fiscal policy was insufficient to significantly alleviate the recession. It was simply too small - as economists predicted at the time. Indeed, if he is so worried about the risk of rising NAIRU, he should be pushing for policymakers to pull out all the stops.

Mankiw is not alone in seeing the challenges posed by protracted unemployment. From Federal Reserve Ben Bernanke's Congressional testimony:

Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects.

The difference between Mankiw and Bernanke is that the latter not only recognizes the problem, but could also do something about it. Not that he is inclined to. Of course, he is not alone. Philadelphia Fed President Charles Plosser was quoted today:

“Lowering the interest rates closer to zero could have very disruptive effects on the financial markets,” Plosser said. “If we bought Treasury bills we could un-anchor expectations of inflation because the public might begin to think we are going to buy up the public debt.”

Plosser repeats the credibility story, arguing that additional action as suggested by Joe Gagnon will trigger an inflationary spiral. Likewise, San Francisco Fed President Janet Yellen expressed an unwillingness to adopt a new inflation target:

Janet Yellen, President Barack Obama’s pick to be the Federal Reserve’s next vice chairman, said it would be “risky” to adopt a long-run inflation goal of 4 percent, and that supervision and regulation are “the first line of defense” against risks to the financial system.

She made the comments in written responses to questions posed by U.S. Senator Richard Shelby, a Republican from Alabama, following her July 15 hearing before the Senate Banking Committee. Yellen, president of the San Francisco Fed, is awaiting confirmation, along with Obama’s other nominees, Sarah Bloom Raskin and Peter Diamond…

...She said that while a higher long-run inflation goal would “give the Fed more maneuvering room in the future,” she agrees with Bernanke that such a move “would be a risky policy strategy.” Most policy makers regard 2 percent as a level consistent with price stability.

I would think that, despite having to endure a higher inflation target, Yellen would be eager to have more maneuvering room. After all, there is not a lot of working room for conventional policy in a liquidity trap. Yet Fed officials seem to prefer the idea that unemployment becomes a long term challenge rather than a short run cyclical issue over the risk of inflation. Like fiscal policy, monetary policy is now limited by imaginary obstacles.

It is worth noting that the long term challenge may already be upon us. David Altig puzzles over the implications of a shifting Beveridge curve, suggesting that extended unemployment benefits may have a role. He then hones in on the possibility of a skills mismatch:

Now I realize that a few anecdotes don't make facts, but I have been in more than a few conversations with businesspeople who have claimed that the productivity gains realized in the United States throughout the recession and early recovery reflect upgrades in business processes—bundled with a necessary upgrade in the skill set of the workers who will implement those processes. This dynamic suggests that the shift in required skills has been concentrated within individual industries and businesses, not across sectors or geographic areas that would be captured by our most straightforward measures of structural change.

To be honest, I hear this complaint too, but have trouble swallowing it. I believed it in the mid and late 1990's, but now? The eight million people dropped into unemployment are all unemployable? Firms are willing to lose profits than do the unthinkable, on the job training, actually invest in their employees? I also have heard the opposite story, of overeducated temporary Census workers desperate for employment, completing assignments in a fraction of the expected time, not realizing that their productivity would only be rewarded with a shorter stint of employment. And if we are experiencing all these magical productivity gains and a shortfall of workers, then wages should be rising quite smartly. But from one of the articles cited by Altig:

Here in this suburb of Cleveland, supervisors at Ben Venue Laboratories, a contract drug maker for pharmaceutical companies, have reviewed 3,600 job applications this year and found only 47 people to hire at $13 to $15 an hour, or about $31,000 a year.

You get what you pay for. To put this into perspective, the average national wage for Wal-Mart was $11.24/hour in 2009. I would hope, however, that Ben Venue Laboratories pays better benefits.

I would really appreciate a good story that explained why we should be happy about high productivity growth if real wage growth is not surging. The lack of the latter makes me question the reality of the former.

Putting my skepticism aside, if a skills mismatch is really a problem, then the solution is to ramp up activity until labor shortages raise wages and force employers to reach deeper into the barrel and in turn bring more people into the labor force to gain those missing skills. Better to do it sooner than later. If the productivity gains are real, the wage gains should not be inflationary. This was the story of the 1990s. Otherwise, policymakers sit and wait as the potential structural rigidities deepen, thereby ensuring a higher NAIRU in the future. And, driven by fear of inflation, this appears to be exactly what policymakers intend to do.

    Posted by on Tuesday, July 27, 2010 at 12:33 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (42)

          


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