For whatever reason (resistance to nominal wage cuts being the most obvious), inflation ceases to be a good indicator of underutilised resources when inflation starts off low and we have a major negative demand shock.First, for inflation to "cease" to be a good indicator of underutilized resources, it must have once been a good one. I have run into economists who think that the unemployment rate is a good measure of underutilized resources. Then, if inflation is a good "indicator" of underutilizaiton, there must be a stable Phillips curve - a negative relationship between the unemployment rate and the rate of inflation.
Clearly, Simon thinks that there has been a "major demand shock" - presumably he means the financial crisis - which caused the Phillips curve to break down. So, suppose we look at the data on CPI inflation and the unemployment rate in the U.K. for 2000-2006. That's arbitrary of course, but if this Phillips curve is so stable, we should see it in the data for that period. Here's the time series (quarterly data):
So after the "major demand shock" - otherwise known as the financial crisis - occurred, what does the Phillips curve in the U.K. look like? We'll first plot the data for 2007-2014 (quarterly) using the headline CPI to measure the inflation rate. Here's the time series:
In case you're wondering what happens if we use core inflation instead of headline inflation, here's what that yields:
Simon goes on:
...it seems quite possible that GDP continues to be quite a few percentage points below where it could be without inflation exceeding its target...So, in spite of the fact that Phillips curve logic is inconsistent with the data - and the problem seems more severe post-recession, Simon continues to use that logic. He imagines that it is underutilization that is holding back the inflation rate, as he states:
...so we continue to waste resources on a huge scale. This is money down the drain that we will never get back. It is like taxing households thousands of pounds or dollars or euros a year and burning that money.Thus, the possibility of an output gap becomes a certainty - it's now a waste of resources on a huge scale.
Simon finishes the post with:
...if, at low inflation rates, inflation becomes a noisy, weak and asymmetric indicator of the output gap, then focusing on inflation is going to perform badly. In these circumstances it could be many years before it becomes clear that we have been continually running the economy under capacity, and needlessly wasting resources. Unfortunately even when that point of realisation arrives, for obvious reasons monetary policymakers are going to be reluctant to acknowledge the mistake.Simon's chief worry is the latent output gap - the inefficiency he suspects is there, but seems at a loss to measure. It's unclear why we can't see it now, but might realize sometime in the future that it was there all the time - massive, and highly persistent. That certainly doesn't seem like a Keynesian inefficiency - or, to be more accurate, a New Keynesian inefficiency - as that's a temporary phenomenon. If Simon is so certain this beast exists, he should be able to tell us what it is.
I think it might help Simon, as a start, if he declares the parrot dead. The Phillips curve is not resting, sleeping, or pining for the fjords. It is dead, deceased, passed away. It has bought the farm. Rest in peace.
The Bank of England has been close to the zero lower bound for a long time. The Bank Rate has been set at 0.5% since March 2009. Here's the latest inflation projection from the Bank: 20 years of zero-lower-bound experience in Japan and recent experience around the world tell us that sticking at the zero lower bound does not eventually produce more inflation - it just produces low inflation.