When an economy is operating at near full employment and people have money to spend, demand for goods and services increases. To meet the demand, companies expand their businesses and hire more workers. However, at near full employment, most workers already have jobs. So companies have to lure workers with higher wages, which, of course, increases the companies' costs, explains the website Biz/ed. The workers then push for higher wages to meet the higher prices and expected price hikes, which increases company costs again. Theoretically, this continues in an inflationary spiral until a loaf of bread costs the proverbial wheelbarrow full of cash.You'll notice that the behavior of governments and central banks doesn't enter into the story. Apparently a wage-price spiral is a self-fulfilling dynamic process which could start under any conditions and continue forever - unless something is done about it. In the 1970s, some policymakers thought the solution to a perceieved wage-price spiral problem was (naturally) wage-price controls. For example, Richard Nixon tried a 90-day wage-price freeze, and the government of Canada imposed wage-price controls for a much longer period of time. Such controls were advocated by economists like John Kenneth Galbraith, who perhaps wasn't taken so seriously by most academics, but even mainstream macroeconomists such as James Tobin could sometimes find "incomes policies" attractive.
In current academic circles, there isn't much talk about wage-price spirals, though of course some ideas never die. Perhaps the primary achievement of the Old Monetarists - principally Milton Friedman - was to convince people that inflation control is the job of central banks, and that wage-price controls only produce inefficiencies (though experience with those policies was pretty convincing as well). So, if inflation control is the job of the central bank, and we think there is something wrong with the inflation rate, we know who to blame. Of course, Friedman seems to have failed to give central banks useful instructions for implementing inflation control. He argued that there is a direct link between money growth and long-run inflation, that monetary disturbances are a primary determinant of fluctuations in real GDP, and that "fine-tuning" is inappropriate. So, Friedman reasoned, the appropriate monetary policy is:
...that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only. But it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced.Like wage and price controls, targeting of monetary aggregates was tried (in the 1970s and 1980s, primarily) and it failed. The relationships among monetary aggregates, inflation, and real economic activity proved to be highly unstable, causing Old Monetarist prescriptions to work poorly. That doesn't stop the proponents of Old Monetarism -a dwindling breed- from trying. We can still find work involving searches for the elusive ideal monetary aggregate or searches for the elusive stable money demand function.
So, if inflation control through money growth targeting works poorly, what to do then? Some central banks opted to target inflation directly or, more generally, there was some recognition that the central bank should take nonneutralities of money into account, and Taylor wrote down a simple rule of thumb that would allow for that. The Taylor rule was subsequently enshrined in New Keynesian models, along with an updated version of the Phillips curve.
The Phillips curve appears to be the modern version of the wage-price spiral. Typically, that's how the inflationary process is described for the lay person. For example, here's from a recent blog post in The Economist:
The American economy, we wrote in July, almost certainly has less room to grow than it used to. Estimates of the economy's potential output, or how much it can produce at a given time without serious inflationary pressure building, have been revised down substantially by the Congressional Budget Office and other economists studying the issue.That was from a piece on potential output in the United States, but what I am interested in is the part about "serious inflationary pressure." Apparently there is more inflationary pressure the lower is the output gap - the difference between "potential" output and actual output. Clearly the writer(s) of this blog post subscribe to a Phillips curve theory of inflation. The Old Monetarists (Friedman) and modern structuralists (Lucas) may have thought they debunked Phillips curve thinking, but it's remarkably persistent. How come?
If you think a stable money demand function is hard to find, try to find a Phillips curve in the data. As with the money demand function though, nothing stops a committed Phillips curve adherent. Whether by finding the right combination of inflation measure and output gap measure, judicious use of Bayesian estimation, or whatever, by hook or by crook a Phillips curve can indeed be uncovered in the data. But, as I outline here, it's hard to make a case that the Phillips curve is helpful for thinking about inflation, its causes, and what to do about it. For example, Phillips curves are not useful in forecasting inflation (see this paper by Atkeson and Ohanian.).
Diehard Phillips curve folks, in extreme states of denial, will insist that the output gap is a latent variable, and thus the existence of low inflation implies that the output gap must be high. Indeed, from the blog post in The Economist, quoted above, if we take potential output to be defined by the behavior of the inflation rate (as seems to be implied by the quote), we should be able to back out a measure of of the output gap from the actual inflation rate. I'm pretty sure that, if you do that exercise, you will come up with nonsense.
But perhaps the Phillips curve - even as complete fiction - has been useful, if for nothing else than to permit agreeement among policymakers. In the recovery phase of a business cycle downturn, supposing the nominal interest rate and the inflation rate are low, an appeal to the Phillips curve can help in obtaining agreement to "tighten," i.e. to raise the policy rate. Even though inflation is low, it can be argued that "inflation pressure" exists, inflation threatens, and tightening should occur before it is too late. Old Monetarists, Old Keynesians, and New Keynesians alike, might find reasons to agree on that. Indeed, I think we can write down models where this would be self-fulfilling, and that type of reasoning - though it may actually be wrong - could yield the right policy decision. The policy decision would be right in the sense that it would avoid the bad equilibrium (bad in the sense of not achieving the central bank's inflation target) that converges to the zero lower bound and low inflation forever - see this paper by Jim Bullard.
So, what does this have to do with Europe? Here's what's happened to the average of inflation rates across countries in the Euro zone:
The recent European experience might look familiar to someone who lived in Japan, say over the period 1990-1995. Here's CPI inflation in Japan:
What is the mandate of the ECB? From the ECB's web site:
The ECB’s main task is to maintain the euro's purchasing power and thus price stability in the euro area.In case it's not clear to you what that means, there is an explanation here. Apparently price stability means that inflation rates between 0% and 2% are more or less OK, negative inflation rates are not OK, and maybe 1.8% is more OK than 0.8%. Suffice to say, though, that the ECB is changing policy, or about to change policy, on several dimensions, so it appears to think that the inflation you see in the first chart is definitely not OK, or projected to be not OK. Draghi's press conference after the policy change makes it clear that he's worried about a decline in inflation expectations, which you can see in breakeven rates on European government bonds.
So, since it appears the ECB wants to increase the inflation rate in the Euro zone, how does it intend to to it? First, the ECB has reduced its policy rates. The interest rate on the ECB's main refinancing operations was reduced to 0.05%, and the interest rate on deposits at the ECB was reduced to -0.20%. The refinancing rate is important, as the ECB does not typically intervene directly in an overnight market as is the case, for example, in the United States, but by lending to financial institutions, and the key lending facility is "main refinancing." The ECB has also taken the unusual step of charging for the privilege of holding reserves at the ECB, i.e. the ECB currently has a -0.20% lower bound rather than a zero lower bound. People - Miles Kimball among them - who think that relaxing the zero lower bound on the nominal interest rate will solve the world's problems get very excited about this. Second, there is a central bank credit program about to get underway, i.e. TLTROs (targeted long-term refinancing operations), which is central bank lending to European financial institutions with attached incentives to encourage these institutions to lend to the private sector. Third, there are planned asset purchases by the ECB - quantitative easing (QE) - with some of the specifics to be worked out later. Again, Draghi answers some questions about this in his press conference. It seems the asset purchases will take two forms: asset-backed securities and covered bonds. A covered bond is basically a collateralized bond, secured by a specified set of assets on the issuer's balance sheet, rather than being subject to the usual seniority rules in bankruptcy proceedings.
What theory of inflation could we use to think about the ECB's change in policy? Though some deflation-scare stories sound something like old wage-price spriral stories in reverse, let's dismiss that. What about Old Monetarism? It's reported in the press conference that M1 in the Euro area was growing at 5.6% in July, and that wouldn't alarm a quantity theorist, I think. However, belief in the Phillips curve is certainly consistent with what the ECB is doing, or proposing to do. Real economic activity is deemed to be weak, so a Phillips curve adherent might think that has something to do with the low rate of inflation in the Euro zone. Then, if we follow Old or New Keynesian prescriptions, conventional monetary easing - lower nominal interest rates - should increase output and inflation. Unconventional easing (QE and relaxing the zero lower bound) could be added to the Keynesian mix, given the zero-lower-bound problem.
But what if we think more carefully about the key elements of the "easing" program?
Starting with the last policy change first - ECB asset purchases (QE) - we might ask why this might matter. The press conference I think makes clear what I have in mind. Draghi says:
So QE is an outright purchase of assets. To give an example: rather than accepting these assets as collateral for lending, the ECB would outright purchase these assets. That’s QE. It would inject money into the system.Then later:
Let me also add one thing, because the ABS may sound more, I would say novel, than they are in the ECB policy-making, and indeed, the modality is novel, because we would do outright purchases of ABS, but the ABS have been given as collateral for borrowing from the ECB for at least ten years, so the ECB knows very well how to price and how to treat the ABS that’s accepted, especially since we have, - and this is in a sense another dimension that makes any precise quantification difficult at this point in time - we have narrowly defined our outright purchase programme to simple and transparent ABS.So, you might ask why it would make a difference if the ECB purchases a given asset outright, vs. extending a loan to a financial institution with the asset posted as collateral. Why would there be a bigger effect - and on what - in the first case relative to the latter?
Next is the TLTRO. Details of this program can be found here and here. This is basically an incentive program for lending by ECB financial institutions, tied to main refinancing operations - a kind of subsidized lending program. There's no particular link to inflation, unless we think there is some mechanism by which more credit - or credit reallocation - matters for inflation.
Finally, let's look at the ECB's interest rate policy, which I want to spend some time on. There are two parts to this. The first is conventional easing, which in the case of the ECB is a drop in its main refinancing rate - the rate at which it lends to financial institutions. The second is unconventional - a drop in the interest rate on reserves to a lower negative rate. The key worry here is that the ECB becomes trapped in a state with low inflation and low nominal interest rates forever, and can't get out. Note that this is a policy trap, not the "deflationary trap" that some people worry about. This is what Jim Bullard discusses in this paper. It's well known that conventional Taylor rules can have poor properties, and can lead to policy traps of this type. If inflation is low, the central bank lowers the nominal interest rate, which leads to lower inflation in the long run due to the Fisher effect. Ultimately, the economy converges to a steady state at the zero lower bound with inflation lower than what the central bank wants, and it can't get out unless the policy rule changes. Further, note that relaxing the zero lower bound won't help. If the central bank charges negative interest on reserves, this only lowers the inflation rate at the low-inflation steady state.
Could a central bank actually get into a low-inflation policy trap and not figure it out? The Japanese case shows us that central bankers can be very stubborn. In the case of Europe, here's what's been happening to the overnight interest rate and the inflation rate over time: just as it does for the United States. Given this, and the first four charts in this post, it might enter your mind that Europe might be going in the same direction that Japan did 20 or more years ago.
How could we think about monetary policy in this context? Our goal is to determine what it takes to increase the inflation rate in an economy, taking into account short run effects, and the Fisher effect, which will dominate in the long run. One model that captures some of what we might be interested in is a segmented markets model. I'm going to use it because it's simple, and the key implications may not be so different if we were to include other types of short-run monetary non-neutralities. A very simple segmented markets model is in this paper by Alvarez, Lucas, and Weber. The details of what I did are in these notes that I've posted.
In the model, there are many households which each live forever. Each has a fixed endowment of goods each period, and sells those goods in a competitive market for cash. Goods are purchased from other households subject to cash-in-advance. There are two types of households - traders and non-traders. A trader can trade in the bond market each period, and holds a portfolio of money and bonds. Non-traders do not trade in the bond market, and hold only cash. The central bank intervenes by way of open market operations, the result being that an open market purchase of government bonds initially affects only the traders. There is a nonneutrality of money, which comes about because of a distribution effect of monetary policy. An open market purchase will increase the consumption of traders in the short run, and it is the consumption of traders that determines bond prices. Thus, when the open market purchase of bonds occurs, this tends to increase consumption of traders and nominal and real interest rates go down. But standard asset pricing implies that there is a Fisher effect - higher anticipated inflation implies a higher nominal interest rate.
In my notes, I work out the local dynamics of this economy. I don't worry about liquidity traps as I'm interested in what happens when the central bank gets off the zero lower bound. If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work - open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).
But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds. A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:
We could add things to this model - liquidity effects on the real rate from scarce safe assets, real effects of monetary policy on aggregate output, etc., and I don't think the basic story would change. The story is that a sustained increase in the inflation rate is not possible unless the nominal interest rate goes up. Further, note that the real interest rate goes up temporarily in the process, and with a more fully developed model, there may be pain associated with that. Of course, in economics free lunches are always hard to find. If we think that higher inflation in the long run is good for us, it's hard to imagine there wouldn't be some cost to getting there.