DO THEY PLAY IT COOL?
Are we seeing an immaculate disinflation because the central bankers are credible?
Everyone of a certain age knows that Fonzie —the character Henry Winkler plays in the 1970s sitcom Happy Days —is cool. He is cool, he is tough, he has a majestic bearing, and when he talks, people listen. But as he tells Richie Cunningham (Ron Howard), Fonzie never fights —because he is so cool and tough, the other side backs down.
I was reminded of this classic scene while thinking about the outgoing Reserve Bank Governor and his central banker peers.
Let me explain.
Bill Phillips had an interesting life long before he started at the London School of Economics in the late 1940s. He was a war hero and survivor of a Japanese prisoner of war camp in Indonesia. He worked as a crocodile hunter in Australia and travelled across China and Russia in the 1930s, and then became an electrical engineer before the war. One easily imagines a Clint Eastwood directed biopic starring Leonardo Dicaprio of his story.
And that’s before we get to his contribution to economics!
He published a paper in 1958 showing an inverse relationship in British data over the 1861-1913 period between the unemployment rate and nominal wage inflation. Figure 1 of this classic paper is pasted below.
The study was replicated for other time periods and countries for which there was data. Within a few years, there sprang a literature about the unemployment-inflation trade off, and fine tuning of the business cycle. Essentially the idea was to use the statistical relationship between the twin ‘bads’ of unemployment and inflation and calibrate monetary policy to offset a small change in one with a small change in the other.
One gets a fascinating glean of the macroeconomic policy thinking pervasive with this ‘trade off’ in John Kenneth Galbraith’s memoir of his time as the US Ambassador to India in the early 1960s. The book has a few interesting pages about China’s invasion of India while the world awaited a potential nuclear war over Cuba. And there are tidbits about social life in Pundit Nehru’s Delhi. But for an economist, it’s Galbraith’s thoughts on macroeconomic management —that it was a simple, technocratic matter to tame the business cycle—that might raise an eyebrow.
These economists surely thought they were oh-so-cool, taming the business cycle, didn’t they!
As it happens, it was Milton Friedman (and somewhat independently, Edmund Phelps) who turned out to be the cool cats of the late 1960s.
Macroeconomists are well known for spending half their time fashioning complicated stories to offer a view, with all the multi-handed prevarications, that turns out to be wrong, and then spending the rest of their time explaining why they got it wrong. Friedman and Phelps were cool because they predicted something quite lucidly that actually happened!
They argued that the apparent inverse relationship notwithstanding, there was no long-run trade off between unemployment and inflation. Workers and employers agree on wages based on their expectations of inflation. If inflation turns out to be different from this expectation, it results in the real wage that is higher or lower than what was agreed upon. When inflation is temporarily and unexpectedly high, the real wage is low, and firms hire more workers, lowering unemployment. This gave the apparent inverse relationship between the two variables observed by Phillips and others.
Not only did Friedman and Phelps explain the Phillips’ Curve relationship, they further argued that if policymakers tried to exploit this relationship by raising inflation a little bit, eventually workers and employers would see through that and raise nominal wage to match the higher inflation. The result would be higher inflation, but no change in the unemployment rate. And this is what happened in the next decade.
The 1970s might have been a cool decade for music, depending on your taste, but it was pretty miserable for the macroeconomy. There were wars in the middle east, budget deficits in the United States, and various other stuff that raised both inflation and unemployment. Crucial for our story is that, just as the two economists predicted, there was no trade off between the two sources of misery. Attempts to reduce joblessness with loose monetary policy only resulted in inflation etching up while the unemployment rate remained stubbornly high!
To quote Bob Marley’s cool paraphrasing of Abraham Lincoln —You can fool some people sometime, but you can’t fool all the people all the time!
Okay, now that you see the light, you might be wondering why the process couldn’t work in reverse to achieve what is now called ‘immaculate disinflation’. Recall, according to the Friedman-Phelps logic, if monetary policy was tightened, and inflation turned out to be lower than expected, the real wage would be too high, and firms would hire fewer workers, raising unemployment. But Robert E Lucas Jr argued that economic agents (employers and workers) were rational, and if they had reasons to expect tighter monetary policy would eventually lower inflation in the future, they would rationally anticipate it and therefore set wages appropriately to avoid any systematic surprise rise in the real wage. That is, inflation would decline without any significant rise in unemployment as long as the disinflation could be rationally expected.
In the late 1970s and early 1980s, and in Australia in the early 1990s, central bankers claimed that they would tighten monetary policy as much as necessary to bring inflation down. If the private sector believed the central bankers, they would set their wages and prices in a way to attain disinflation without any significant or prolonged rise in joblessness.
As the chart below shows, this is not what happened. The early 1980s recessions in the US and Britain, and the early 1990s one in Australia, were disinflationary, but they were not immaculate —joblessness increased everywhere.
In a 1977 paper and its follow ups, Fynn Kydland and Ed Prescott why the disinflation process was not painless. In their telling, the central bankers were not cool enough!
Suppose you have a dog, or a toddler, and you tell them that ‘this is it, no more treats or play today’. What do you do when they throw a tantrum? If you give in, then they know that you are a softie and they won’t listen to you next time. In such times, giving in ain’t cool. Of course, any parent or pet owner knows that in such times, holding one’s nerve is tough.
So it is for monetary policy. In the 1970s, central bankers promised to keep interest rates at an elevated level until inflation came down. But could they be trusted when their political masters’ re-elections were threatened by high unemployment? And more generally, could the authorities be trusted to not fiddle with monetary policy to ‘surprise’ the private sector with a little bit of inflation and a little less unemployment during a tough election year?
Kydland and Prescott argued that as long as the central bankers, or their political masters, had discretion to choose monetary policy setting, they would not be credible enough to be trusted. Their solution was for the central bankers to commit to a transparent and clear rule to follow, and earn their credibility by sticking to the rule in difficult circumstances.
Only two economists could come up with the catch phrase ‘Rule is Cool’.
Okay, they didn’t actually use that phrase as far as I know, but they should have! Independent central banks with a clearly articulated monetary policy framework became the norm across the advanced, and many emerging, economies over the subsequent decades. In effect, most central bankers’ policy mandate had become keeping inflation at or below a certain range or rate.
The intuition behind the monetary policy framework used by the central bankers after disinflation had been attained was along this line: inflation is bad and can be controlled by interest rates; by anchoring inflation expectations, central bankers can at least manage that malus; unemployment is also bad but should be dealt with through other levers (such as job search support, training, wage subsidies and so on) that are not the metier of central bankers.
As an aside, it's interesting that the recent RBA review essentially discards the past three decades of received wisdom, saying that once again the RBA should target full employment together with inflation with their single instrument. This post is already rather long, so perhaps this is best left for another piece in future.
Since the 1990s, there have been asset price booms and busts, financial crises, debates about the public finances, but at least in the advanced economies, inflation had not been an issue. Of course, these decades have also seen positive shocks such as new technology, globalization, increases in global labour supply by hundreds of millions of people, better functioning and governed markets in various specific sectors and so on. This being economics, there is never anything definitive — but notwithstanding the positive shocks, the rule-following central bankers told each other, and everyone else, that they were now cool (that is credible) and they could whip inflation now!
Then came the pandemic, the Great Lockdown, monetary and fiscal support to cushion households and firms, vaccines, reopenings of the economies around the world in fits and starts, supply chain bottlenecks, and surge in demand from cashed up households. Inflation started rising in 2021, and continued to surprise everyone on the upside even before Putin invaded Ukraine (see the chart below from the IMF’s World Economic Outlook Update, January 2022).
What would the rule-following cool central bankers do in such a situation?
If they had good reasons to believe that the inflationary surprises were all because of supply issues that were beyond their control, they would try to convince everyone that inflation would eventually dissipate. But if there were enough grounds to think that at least some part of the surprisingly high inflation was because of demand, their continued coolness (that is, credibility) depended on tightening the monetary settings to dampen demand in the economy, even if it led to a rise in unemployment if not an outright recession.
And if they were really cool —and lucky with whatever other things were happening in the economy that they couldn’t control —the monetary tightening could in fact lead to disinflation without much labour market pain.
Details vary across countries reflecting idiosyncratic factors, but arguably the broad pattern in the advanced (and the better governed emerging) economies seem to be that this is exactly what has been happening —central bankers said that they would tighten monetary policy to bring inflation down, firms and employers have believed them and set wages and prices accordingly, and inflation is coming off without much of a rise in the unemployment rate, at least not yet.
Of course, this could change in future. But as of now, can we say that they play it cool?
A personal anecdote. This one handed economist was flying home from Washington DC once, and the flight landed in LAX so late that he had given up any hope of getting on board the next leg to Sydney. The RBA Governor was sitting in front of him, and told the airlines crew that the one-handed fellow (and his immediate boss) were part of the Governor’s entourage. All were escorted to the Qantas Club without the long lines and security rigmarole, with enough time for a drink.
That was cool, Mr Governor.
Further reading
When central banks become one-stop policy shops
Central banks are under pressure to cure social ills
Rachana Shanbhogue, 23 April 2022
The Federal Reserve’s great anti-hero deserves a second look
Lessons for modern policymakers from Arthur Burns
Economist, 20 December 2022
Ricardo Reis: ‘Central banks must balance bringing inflation down without breaking things’
The LSE economics professor considers how monetary policymakers should navigate the trade-offs which lie ahead
Tej Parikh, 22 December 2022
A neglected tool of central banks shows its worth
Money supply numbers have been sending important signals before and during the pandemic
John Plender, 21 Feb 2023
Nobel laureate Edward Prescott, 1940-2022
He and Kydland were the architects of … the literature on time inconsistency, which has reshaped our thinking about the credibility of government commitments… and … monetary policy.
Rajnish Mehra, 25 Feb 2023
Farewell to the most influential macroeconomist of his generation.
Noah Smith, 16 May 2023
Central Banks Can Fend Off Financial Turmoil and Still Fight Inflation
But there are trade-offs between price and financial stability during times of stress, especially when inflation is high
Tobias Adrian, Gita Gopinath, Pierre-Olivier Gourinchas
June 5, 2023
The RBA wants to raise unemployment to fight inflation – but who will that hurt the most?
Greg Jericho, 13 July 2023
Discombobulation, Recombobulation and Disinflation
Paul Krugman, 21 July 2023
Cooling price rises will have counterintuitive consequences for the Federal Reserve
Economist, 26 July 2023