In Economic Theory Folklore Inflation Is Caused by Low Unemployment, Not Fast Growth

Thursday, 15 August 2013 07:18

Neil Irwin has a discussion of the growth potential of the U.S. economy that follows the work of two JP Morgan economists. The basic story is quite pessimistic, arguing that we will see rapid declines in labor force participation and much slower productivity growth in the future. I won't comment on these points at length here (the evidence presented is limited in the piece and weak), but will rather focus on the conclusion.

The piece ends by warning readers:

"And if the analysis is right, and we have downshifted to a slower pace of potential growth, we will hit the speed limit of this recovery — the point at which inflation becomes a risk — sooner than forecasters are commonly thinking."

The standard theory about the causes of inflation is based on the unemployment rates. Folks have probably heard of the non-accelerating inflation rate of unemployment (NAIRU). The logic of this theory is that at lower rates of unemployment there is more upward pressure on wages and prices, meaning that the inflation rate increases. At higher rates of unemployment there is less upward pressure on wages and prices, which means the rate of inflation decreases. 

The NAIRU is that wonderful level of unemployment at which the inflation rate will stay constant. For true believers, it is the unemployment rate that the Fed would target since it is the lowest unemployment consistent with a stable rate of inflation.

There are lots of good criticisms of this view, but some permutation of it dominates the vast majority of mainstream thinking about the economy. Note that it does not say anything about growth. The non-accelerating inflation rate of unemployment is a story about unemployment, as the name implies.

Growth can enter into the picture if the unemployment rate is actually at the NAIRU. In this situation, if the economy grows at a rate faster than its potential (it can do this for short periods of time), then the unemployment rate would fall below the NAIRU and we would then see accelerating inflation. But the key variable in this picture is still unemployment, not growth.

This is important for two reasons. First, there is no limit on the economy's ability to acheive rapid growth as long as we have an unemployment rate above the NAIRU. Even if the rate of growth of potential GDP is just 2.0 percent, the economy can still have a spurt of 6 percent, 7 percent, or even 8 percent, as long as there is large amounts of slack in the economy, as is the case today.

The other point is that unemployment is something that people see and experience. Growth is not. The key economic debate is how low the unemployment rate can go -- how many people can have jobs -- not how fast the economy can grow. We will find that out when we get the unemployment rate as low as possible without serious problems with inflation.