David Andolfatto on Inflation and the Phillips Curve

The breakdown in the Phillips Curve relationship between inflation and unemployment may be one reason why inflation hasn’t taken off as expected.

David Andolfatto is the Vice President of the St. Louis Federal Reserve Bank and has published widely in the field of monetary economics. He also writes for his blog, MacroMania, where he covers a multitude of economic topics. David joins Macro Musings to discuss the economics behind the Phillips Curve, and to help provide a greater understanding of the debate surrounding it. They also discuss the mystery of low inflation in the United States, the excess money demand problem, and the important role debt plays within international monetary policy.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: David, welcome back to the show.

David Andolfatto: Oh, hi David. Thanks for having me. Before beginning, I'm going to have to give my disclaimer.

Beckworth: Sure.

Andolfatto: I would like everybody to know that the views that are put forth here, the opinions that I express, are exclusively my own, and should be in no way or not necessarily the views shared by my colleagues here at the Federal Reserve Bank of St. Louis or anywhere in the Federal Reserve system.

Beckworth: You stirred up something of a hornet's nest. Of course this hornet's nest was already stirring, and I want to begin by giving the backstory behind this discussion that we've had on Twitter, and blogosphere, and the Federal Reserve officials have been having themselves; and this is the inflation mystery. So the Fed's inflation target, it targets PCE inflation officially, and it also looks at core PCE inflation, which removes energy and food; because it's more volatile. The headline PCE inflation rates since the recovery ... And I'm dating this right after June 2009 when the economy turns around, it is averaged 1.4%, and that's the headline PC rate.

Beckworth: And then the core PC inflation's average 1.5%. So the Fed is targeting 2%, and it is persistently hitting below that. The average is below that, and it's become a puzzle, a mystery. And just to be clear to our listeners, I think most of them know this, the Fed's inflation target was officially adopted in 2012, but even before then, it was kind of unofficially and implicitly following something close to 2%. And this has been interesting to watch, because there's been numerous articles written and speeches given, and debates had over why inflation has persistently undershot its target. I just want to run through a few articles with their titles just to give you a flavor.

Beckworth: And interestingly, David, as I was looking this up, I found articles as far back as late 2014. In fact, the Wall Street Journal had an article in November 2014 titled, Fed Faces An Inflation Conundrum. And then as we move, here's a New York Times article from early 2015 with the title, Omens Of The Fed Struggle With Prices; lovely title. Central Bankers Grapple With Inflation Puzzle, from financial Times later in 2015. Many other similar titles to that, The Fed's Inflation Puzzle, Wall Street Journal in 2017. Real recently, Bloomberg Businessweek had an article, The Great Inflation Mystery.

Beckworth: So if you look out and you look at what's happening to inflation, there's a mystery, a puzzle, conundrum that's occurring. And the stated reason is because of Phillips Curve. So can you help us understand why the Phillips Curve is creating so much bewilderment about the inflation rate?

Inflation and the Phillips Curve

Andolfatto: Yeah, sure. I think it's basically ... Because according to, more or less, conventional way of thinking about things, there exists a so-called natural rate of unemployment, and a Phillips Curve relationship, which is a negative relationship between either wage or price inflation, and the rate of unemployment.

Andolfatto: And the idea is that to the extent that the aggregate demand is bumping the economy around, and aggregate demand manifests itself as higher or lower rates of unemployment, that in a period when unemployment rate is low, that aggregate demand is supposed to be high. And the unemployment rate is below its so-called natural rate, and that this will ultimately manifest itself as some soft of a competition in the labor market, leading firms to bid up nominal wages, passing along the cost on to consumers. So that one could one can expect, in times of low unemployment, to sooner or later manifests itself as a persistent rise in the price level and, conversely, in times of depression.

Andolfatto: The fact that this doesn't seem to be happening is not necessarily something that's inconsistent with the Phillips Curve theory. Because the Phillips Curve theory does have a free parameter in that the natural rate of unemployment is not something that is directly observable. And so that in order to understand why, for example, in the period of time you alluded to since the crisis, why inflation has been so low, one could, in principle, appeal to the notion that what has been happening is that the natural rate of unemployment itself has been falling over time.

Andolfatto: And that's basically gotten people along so far, but with the unemployment rate now down to about 4.1%, very, very low by historical standards, many people are just ... They are refusing to believe, I guess in their own minds, that the natural rate of unemployment could be any much lower. And that, therefore, the missing inflation is a bit of a conundrum.

Beckworth: Yes. And many Fed officials themselves were warning about crossing that natural rate threshold several years back. They were convinced that if we don't start raising interest rates, we're going to have higher inflation because unemployment had reached a point where it would start to generate inflation through the Phillips Curve.

Beckworth: So the Phillips Curve saying, "We've exhausted all the slack, we've got to have price pressures emerging." And it hasn't happened. Now, you mentioned one explanation, one way around that is to simply argue the natural rate of unemployment has fallen, and will continue to fall. Some also argue about a Phillips Curve being flatter, is that right?

Andolfatto: That's right.

Beckworth: And what does that mean?

Andolfatto: Oh I guess that's in reference to ... If you take a look at the rate of inflation over, as you say, during the end of the last recession, it's been undershooting it's about 1.5% or maybe up to 2% sometimes. But the rate of inflation hasn't varied very much over the last decade, let's say. And yet the unemployment rate has fallen from a peak of 10% during the peak of the crisis, down to 4.1% today. So to say that the Phillips Curve appears to have flattened is simply a statement saying that the relationship is second cyclical, the ... I hesitate to say cyclical, but the co-movement between unemployment and inflation seems to be absent.

Beckworth: Yeah, so there's a breakdown in the relationship is one argument, one justification for why inflation hasn't taken off. You mentioned again that the national rate falling, Joe Gagnon from the Peterson Institute for International Economics, he had a little piece he wrote up where he wrote, "There is no inflation puzzling."

Beckworth: His argument is, "Look, when you get close to 0% inflation, and inflation gets really, really low, people are reluctant to cut prices and wages and, therefore, the Phillips Curve gets flatter, and we would expect to see what we're seeing." And he argues maybe after 3% inflation or so, you'll see the Phillips Curve kick in, and it won't be so fun anymore. So one explanation is the Phillips Curve is flatter but, again, this begs the question why is it getting flatter? And it appears to be getting flatter and flatter, and some say it's disappeared all together.

Beckworth: So you could throw out the natural rate. If the client has an explanation, you could say the Phillips Curve is getting flatter as an explanation. I saw another recent explanation given by Nick Bunker at Equitable Growth, a think tank. And he argued that there's less bargaining power now with labor share of income going down, and that as labor share of income declines, there's less bargaining power, we see less wage and price pressure; just another form, again, of the Phillips Curve argument. Are there any other stories that we know about that people who believe in the Phillips Curve would say explain it other than the ones we've discussed.

Andolfatto: I'm not familiar with any other-

Beckworth: Okay.

Andolfatto: Argument. The one that Nick Bunker promotes and many people have ... I've heard similar things like that. I would throw out a challenge to them that a change in bargaining power, at least theoretically, should manifests itself over long periods of time as changes in the real wage, not a nominal wage, not in a persistent change in the nominal wage. So I'm kind of skeptical about these stories that rely on real wages that should affect real wages, of how they ultimately manifest themselves as persistent changes in the rate of growth of the price level.

Beckworth: Okay. So the Phillips Curve story is being strained, to say at least. And even its most fiercest advocates, they've been given pause given this incredible journey to low unemployment and still really, really low inflation. And again, I just want to stress that there've been many people, many observers including Fed officials telling us several years ago that we were going to have high inflation because we reached a point in the Phillips Curve where the slack's been exhausted, and inflation is going to take off.

Beckworth: And that was a justification for raising interest rates starting in 2015 and afterwards, and yet there hasn't been this increase in inflation. So there's been a puzzle, and one could even argue that based on that reasoning, maybe the Fed raised rates too quickly. But let's step back, get away from discussing Fed policy and focus more on this mystery. You have jumped into the conversation and presented an alternative view, one that looks more at money supply/money demand relationships. So tell us what do you think is going on behind the low inflation?

Explanations for Persistent Low Inflation

Andolfatto: Yeah, I want to say that first of all, in terms of the puzzle relating to the conventional Phillips Curve view, I mean, it really depends on your perspective of what's so puzzling out there.

Beckworth: Mm-hmm (affirmative).

Andolfatto: The puzzle really relates to those people who wish to adopt that view, and assert that the natural rate of unemployment is say 4.5% or something like that. If one is willing to let go of this notion of a relatively fixed or this lower bound, if you like, on the natural rate of unemployment, the puzzle disappears, and you won't then just simply make reference to the notion that the natural rate tends to vary over time; so it's not a puzzle from that perspective.

Andolfatto: In terms of kind of an alternative way of thinking about inflation dynamics, I mean, I've been a proponent of as many others have; it's not unique to me of course. But this notion that another possibly complimentary way of viewing the phenomenon of inflation is to view it through the lens of a more traditional money supply, money demand, fiscal policy sort of view. And by money supplying and demand, I mean, not in the context of narrowly defined monetary aggregates, but in the context of a theory that understands and respects the fact that, especially in recent times, that the U.S. Treasury is a defacto kind of source of a monetary object, if you like; it's a very close substitute to central bank reserves.

Andolfatto: And as such, we live in a world where the issuance of U.S. treasuries is virtually a form of monetary policy; I mean, that's one point to point out. And the second point I'd like to stress is that this theory does not just ... This theory identifies the importance not only of money supply, but also money demand. And again, I mean, broadly the demand for safe assets like U.S. treasuries, U.S. dollars. So this is nothing kind of revolutionary, this is just bringing supply and demand analysis to monetary objects and using kind of more or less conventional monetarist ideas to think about the forces that are generating inflation.

Beckworth: Okay, so you're telling a story where the money supply relative to money demand is driving the relatively low inflation? And some have argued, "What one and a half percent? We're getting worked up over one and a half percent.

Andolfatto: Sure.

Beckworth: But I do think it's important for the Fed's credibility to its targeted, they persistently undershoot and something's not working.

Andolfatto: Yeah that's right.

Beckworth: Especially since [inaudible] years.

Andolfatto: But I mean, on the other hand ... So let's follow through with the way that I'm thinking about this. So there's the U. S. treasuries a very, very close substitute to U.S. dollars; okay, let's take that as a premise.

Beckworth: Okay.

Andolfatto: So anything that affects the demand for U. S. Treasuries, by virtue of the fact that it's a close substitute to the U.S. dollar, is going to affect the aggregate demand for real money balances broadly defined. An increase in money demand for a fixed interest rate ... Like remember the Fed was pegging at 25 basis points, and increase in money demand will, ultimately, manifest itself as dis inflationary pressure.

Andolfatto: I mean this is my interpretation, for example, of why when the Chinese increased their demand for U. S. treasuries, they're willing to cut the price of the exports that they send us in order to acquire these monetary objects. This could, in part, account for the low inflation rate for imports, for example. So if we think about it through this lens, there were a lot of forces that kind of increase the demand for monetary objects like U.S. dollars and U. S. treasuries in the crisis, and in the years following the crisis.

Andolfatto: We had, of course, the flight to safety because of the crisis, we had the crisis in Europe, we had since then an enhanced demand for these monetary objects through the regulatory reforms, Dodd–Frank reforms, Basil III reforms. So we've seen a lot of a lot of indirect evidence, at least, that there's been an enhanced growth in the demand for these monetary objects. At the same time, even though the supply of U. S. treasuries rose very rapidly during the crisis, I mean, the rate of growth of nominal debt has decelerated considerably, at least not until recently. And not too long ago, we were talking about debt ceilings and things like this, and-

Beckworth: Yep.

Andolfatto: The idea is there's still this enhanced worldwide demand for U.S. money, and U. S. Treasuries, and the supply of it didn't seem like it was forthcoming. And I argue that all of these factors could possibly conspire to be dis-inflationary. And this is a statement that's largely independent of what the unemployment rate is doing, although anyone could layer a Phillips Curve argument on top of this as well. And so this is one interpretation I offer as the one reason why inflation could have been so low for so long, and that barring kind of some turnaround in the rate of growth of the demand for these objects, we could expect this low inflation going forward.

Andolfatto: And, of course, what's happened recently is I think that we've witnessed this kind of little bit of a turnaround; we've seen some evidence of it. We've seen some evidence of a significant change in fiscal policy that's projected to increase the rate of growth of the supply of these objects, and we've also seen considerable evidence of a decline in the foreign demand for these objects. So these are forces that pose inflation risks through the lens of the theory. And again, it's nothing ... I don't have to rely the natural rate of unemployment to understand how the forces of supply and demand for broadly defined money manifest themselves as inflation.

Beckworth: So maybe one of the challenges for fans of Phillips Curve thinking is to embrace this idea that money is more than just your standard M2 aggregate or-

Andolfatto: Yes.

Beckworth: M1 aggregate. And maybe if they were to think hard and appreciate the point that you're making, that if you look at all money assets, which include treasuries, treasuries effectively serve as money for institutional investors. And if you look at that relative to the demand for them, there is this shortfall. And I think that's part of the story we have to tell, because I'm very sympathetic to this, and I think listeners of the show will know that there's both retail money assets, which you and I would use and small businesses, and then there's institutional money assets. And the run on the shadow banking system was a run on those institutional money assets and it did collapse.

Beckworth: The VISIA Inform Measure which kind of gets at this, and it shows the collapse in 2008. And even though it's recovered, it's still below the trim path it was before, and relative to demand, clearly it's below. But I want to maybe flush this out a little bit more. So you're telling a story that we need to embrace a broader view of money. I totally get that, and I endorsed that too; I think it's an important idea. Because the government's liabilities, which create this inflationary pressures of both the monetary base and treasury liabilities.

Beckworth: Now I want to maybe expand it even beyond that in the following ways. I think part of the influence on the low inflation might also be the velocity of these monetary liabilities. And that, in turn, might be influenced by the future fiscal condition of our government. In other words, if the bond market expects that there's going to be more debt monetization in the future, that shouldn't influence the velocity today, right? So the health is-

Andolfatto: I think it's critical [inaudible].

Beckworth: Okay.

Andolfatto: Yeah, it's ... You're probably more familiar than most, but you'd go to the fiscal theory, that price level, those papers that stress the fiscal side of how it interacts with monetary policy. I mean, all of these ... The theories vary. The theory, at least, is very, very clear that the way that monetary policy interacts with fiscal policies is absolutely critical for generating inflation, or what people expect about inflation.

Beckworth: Okay. So just to summarize, there's both kind of a short run component or a contemporaneous component, which is the supply of treasuries and monetary base today. But then there's also this forward-looking part of what you're saying is that in the future, will the government be running enough surpluses to pay off its debt?

Beckworth: And if that's not the case, if there's going to be some debts that it doesn't pay off, eventually it has to monetize it, then people today want to unload some of those securities, some of that money and that increases velocity. So there's both kind of maybe a shortfall for today's demand, but there's also some pressures from forward-looking bond market players. Which one do you think is more important? That the outlook for the future health of the government's finances or just the current supply today?

Andolfatto: That's a good question, and I think that is a question that ultimately has to be answered empirically. I mean, I go take a look at the inflation nominal debt dynamic in many countries around the world, and it definitely does seem like there that there's a bit of both elements at work. The idea that the fiscal authority might be planning to monetize future debts isn't critical. I mean, the fact that the fiscal authority does actually monetize its debts contemporaneously. Well, obviously, I think even Phillips Curve guys will understand, it's just kind of aggregate demand.

Beckworth: Yep.

Andolfatto: A make a lot of money chasing fewer goods, it's going to because the contemporaneous price level to rise independent of what people are thinking about in the future. To the extent that people are forward looking, and do have some expectation about how far the fiscal authority is going to take things, I think will only serve to exacerbate these forces, but I don't think it's kind of critical.

Beckworth: Okay. So just to recap, there's a demand for money that's broader than just the standard M1 and M2 monetary base that you learned in your principles of macroeconomics class. There's a broad measure of money, there's elevated demand for it, and that's evidenced by the relatively low interest rates. Even now, 10 year treasury yields are what, 2.9% or so? Which is still really low compared to historical; before the crisis, there were above 5%. So there's still less elevated demand. And that demand for our debt really suggests that there's a shortfall of money.

Beckworth: And this is probably one of the hardest parts to communicate, or to share with folks who maybe don't think this way. And that is the world is basically asking the U.S. government to produce more debt. Even though maybe we don't need it domestically, internationally the world's knocking at the door of the Treasury, "Please, please give us more debt." Is that right?

Andolfatto: Correct. Yes, that's basically it. That's a part of the great privilege of the U.S. has in supplying the world with a reserve currency and the reserve asset, yes.

Beckworth: But that's a tough point to make, and I could never imagine a politician running on that saying, "Look, I want to create more safe assets for the world, which means more debt for us." I don't think he'd get very far in an election if he did that, because it's-

Andolfatto: No, but it is just a simple extension of even if you think in a closed economy.

Beckworth: Mm-hmm (affirmative).

Andolfatto: Right? With the government having net debt outstanding that it needs never repay. And this net debt circulates within the economy as an exchange medium. I mean, the principle's exactly the same there. I mean, the government need not-

Beckworth: Yeah.

Andolfatto: Ever repay that debt that circulates, and serves a very valuable role in financial markets. It lubricates financial markets, it's a source of collateral in a variety of markets, and credit derivatives, and [inaudible]. And so now we extend this to foreigners. I mean, the principle's the same, except now foreigners are exporting their goods and services to us in exchange for our paper. And this manifests itself as trade imbalances for the United States but, in a sense, we're exporting our paper to them that they find useful for some reason, and we get goods and services.

Beckworth: Yeah, I like to tell folks that President Trump is missing an important area where we have already won the trade war, and that's an exporting debt. We are doing a knockout job exporting safe assets to the rest of the world. That's our comparative advantage, we are winning this. And if he could just shift his focus on to that, and be less worried about other trade areas might be a better place.

Beckworth: But this is a good point because I recently had Danielle Gabor on the show. She's in England, but she's doing work on safe assets in Europe. And one of the big discussions over there is can they create a truly European safe asset? And there's talk of a European safe bond or SBs where they would have basically securitized bond with government debt behind it. And it's not clear that would work very well, but they're talking about this because there is this shortage. They recognize this point that you made that there's an appetite for truly safe assets and, right now, the safest bet on the planet is the U.S. government.

Andolfatto: That's right.

Beckworth: Okay, well let's take this understanding and then move it back into the Phillips Curve discussion. So what you're articulating is that there's basically an excess money demand problem, that there's more demand for monetary assets than is currently being supplied, and that may explain the relatively low inflation, and that may be an easier story to tell relative to the Philips Curve. People are straining over backwards to explain why we have low inflation with the Phillips Curve. And what you are articulating, I think is, "Look, it's a lot easier story to tell folks if you just tell this story." Is that right?

Andolfatto: I think that's one way to view it, in fact. And remember, I don't necessarily think these two views are mutually exclusive. I mean, they both emphasize kind of different parts of the economic forces that are at work here. One reason why I wanted to promote this alternative perspective was because I was worried that U.S. policy makers, by focusing too much on conventional Phillips Curves notions, would potentially fall into the trap of being too aggressive in their interest rate hikes.

Andolfatto: Because if one is wedded to the idea that the natural rate is high, and we can see the unemployment rate falling, and if one is wedded to the idea that this just has to manifest itself as future inflation, then one is going to want to act preemptively. And I think that one can very clearly see this type of thinking among people at the FOMC. And that's perfectly fine I think to think that way, but I think it's also useful to temper that interpretation. And one way to temperate it, of course, is as Chair Powell mentioned was the willingness of the FOMC to be data dependent, and to consider the possibility that the natural rate itself is falling; that's one way to temper it.

Andolfatto: Another way to temper it is to kind of view the inflation process through the lens of the model that I just outlined. That if we were to understand that one reason for the surprisingly low inflation is the elevated world demand for safe assets like the U.S. dollar and the U. S. treasuries. That this might permit us to understand where some of this inflationary pressure is coming from, we might be less inclined then on that ground to raise our interest rate policy too aggressively.

Beckworth: Yeah. It's been interesting to watch the FOMC wrestle with this issue. I know your boss, for example, comes at it from a different perspective. He doesn't embrace the Phillips Curve, if I understand him correctly. Whereas most of the FOMC does but, as you mentioned, they've measured their belief in it. Some view it as flatter, some are still puzzled scratching their chin trying to figure out what's going on.

Beckworth: It'll be interesting to see, moving forward, if this incident, this period of low inflation and seemingly tight labor markets leads to a deeper reconsideration of the mechanism behind inflation. Right now all I see ... Maybe you can correct me if I'm wrong, all I see is just trying to make the Phillips Curve work better. Adjust the parameters, flatten it, lower the national unemployment rate. But do you get a sense there'll be some kind of deep soul searching from this experience?

Andolfatto: I should hope so. I think that my experience has been that people serving on the FOMC are very open minded to different views. I mean, it's not like we ... They, like us, we don't change our religion overnight.

Beckworth: Right, fair.

Andolfatto: We have to be persuaded as the evidence kind of weighs in against us. And like I said, this doesn't necessarily require a whole lot of soul searching, but perhaps a little less reliance on one particular way of interpreting the data. Yeah I mean, we'll see. I mean, I can't say for sure, but my experience suggests that perhaps so; I hope so.

Beckworth: Okay. Very nice. Well David that's a great optimistic take. There's some folks, though, who still seem fairly wedded or at least misinterpret what you meant in your conversation on this topic. And I want to turn to one person, in particular, one very prominent person, and that's Paul Krugman.

Andolfatto: Mm-hmm (affirmative).

Beckworth: And he accused you of 'Immaculate inflation.' So this term immaculate inflation. And let me read to you and our listeners, this is a brief excerpt from his piece where he replied to you. He said, "I see that David Andolfatto is added again, asserting that there's something weird about asserting an unemployment inflation link, and that inflation is driven by an imbalance between money supply and money demand. Look, economics is about what people do. Whatever you think is the ultimate because of an economic phenomenon, your story about how that phenomenon happens has to include an explanation of how people's incentives change. Even if you think that inflation is fundamentally a monetary phenomenon, wage and price centers don't care about money demand. They care about their own ability or lack thereof to charge more, which has to, has to evolve the amount of slack in the economy."

Beckworth: Okay, that's Paul Krugman's response to you, and it sounds like to me that he's concerned about the [inaudible] mechanics. So what is your response to him? I know you actually had a followup post, but how do you reply to that?

Responding to Paul Krugman’s Critique

Andolfatto: Yeah, I mean, I think that in my followup post, I remarked that I found very little to disagree with in terms of what he-

Beckworth: Mm-hmm (affirmative).

Andolfatto: Was saying. I think maybe he misinterpreted some of the things I was saying. And I went to some length in a followup post to see where we might bridge our gaps and understanding. He says that I was asserting that there's something weird about asserting an unemployment inflation link. I don't recall asserting anything weird about it.

Andolfatto: In fact, I went out of my way to point out that one can clearly see in recessionary episodes, at least those episodes not driven by oil price shocks, that there's a clear negative relationship between inflation and unemployment. But what I was really talking about was the non-recessionary events, the kind of longer term during the recovery phase. I remarked that very often inflation and unemployment seem to move in the same direction for many years in a row.

Andolfatto: So I was really ... Maybe there's a bit of confusion here; possibly my fault for not being clear that I wasn't talking about asserting that there was no link between inflation and unemployment. He's done this ... In terms of I guess his other broader point about a story having to explain what incentives are being changed for people to act in different ways; I mean, I wholeheartedly agree with that. And I think that I've been guilty of not being clear enough; a lot of economists are. We have to remind ourselves constantly, the way Paul does, that we have to be clear about what incentivizes people to change their behavior. Let's see he says ... What did he say?

Beckworth: Well he says-

Andolfatto: If you think that inflation is fundamentally a monetary phenomenon, which you shouldn't ... Wage and price setters don't care about money demand, they care about their own ability or lack there off the charge more, which has to do with slack in the economy. I mean, I think it's kind of funny. I mean, wage and price setters don't care about aggregate money demand. I guess that's true, but whenever a retailer cuts the price for his goods, he's implicitly increasing his demand for money. So what is it that motivates a retailer to cut their price? And for me, I interpret that as an increase in money demand. So I'm led to believe that maybe some of the disagreement here is just semantic.

Beckworth: Well, yeah, let me push back on Krugman's point because-

Andolfatto: Sure.

Beckworth: We have this whole discipline called finance. Where a big part of it is about rebalancing portfolios; people and firms respond to incentives. People do care about what assets they're holding, what composition of assets they're holding. During a recession, people try to rebalance their portfolios in a very significant way towards the liquid assets toward money. They're not mindlessly doing this, they're doing it because they're consciously aware they need liquidity, there's uncertainty, their precautionary demand goes up. And then, at some point, once the recession ends, maybe their demand for liquidity gets satiated, they don't need to do that as much, they start to spend again.

Beckworth: So I do think you can tell a incentive, microeconomic story from an asset side. People do rebalance portfolios all the time, your home, your car, your cash, or retirement account. And even people who may not have all those assets, they're still constantly thinking about money. And this is where I think it's important to recognize money is a very different asset and very important. Money is the one asset on every market. You mess with that one asset, you're going to mess with every market; so I do think there's something there. Now I do think ... Let me come back and try to bridge a gap with what Paul Krugman is saying.

Beckworth: I do think when people rebalance their portfolios, when real money demand changes, it will have an effect on spending more broadly and, therefore, on slack. If people start spending more, and prices get bid up because of that spending because they're rebalancing the portfolios, and if there's nominal wage rigidity or output price rigidity, then there can be real effects and vice versa. So I think there is a maybe identification problem here, but I do think you can tell a reasonable microeconomic incentive driven story through money as well.

Andolfatto: No, I think you're right. And I think actually ... I'm not sure if it's so much of an identification problem as much as it's just looking at the two sides of the same coin.

Beckworth: That's fair.

Andolfatto: I mean, he's very, very comfortable in thinking about slack and a fall in the aggregate demand for goods and services. Well the other side of the coin of that is just an increase in the demand for money safety. And so these two apparently different phenomenon are, in fact, just two sides of the same coin. So there's really not any need to disagree, I don't think, too much on this. And, indeed, at the end of the day I might add, because I think this is probably the most important part, at the end of the day he agrees with my policy conclusions.

Beckworth: Hmm. Explain that.

Andolfatto: Well he says that the Fed might be ... And he starts out his post, he answers three questions says, "Does the Fed know how low the unemployment rate can go?" No, "Should the Fed be tightening now even though inflation is still low?" He says, "Probably not." He thinks that the Fed might be making a mistake, and he lists several reasons for why that's the case. My own post was motivated by the same problem. I gave kind of a different set of reasons for why, perhaps, the Fed could be walking into a mistake. So at the end of the day, I look at his response and I go, "Yeah, we both agree on the policy recommendation." So perhaps there's not really too much substantive in our views after all.

Beckworth: Yeah, that's fair. And going back to the two sides of one coin, George Selgin had this comment I saw, it was on Twitter in a blog somewhere. But he wrote, "Unemployment and inflation are both consequences of the same cause, which is declining nominal demand or spending. It is as silly as saying that overflowing gutters are caused by open umbrellas when both, in fact, share common cause, heavy rain."

Beckworth: So if there is this uncertainty shock, this fear that causes rebalancing portfolios, you're going to see a change both in inflation and unemployment usually. Now with that said, I want to point to some episodes where you don't see that happening, not including that this present period we're discussing. But Scott Sumner had an interesting post, he replied to this conversation. You had your posts, David Glassner, I believe, had a post and, of course, there's a lot going on Twitter, Carol Baum wrote a piece, I believe, for MarketWatch.

Beckworth: So there's been an ongoing conversation about this. But Scott Sumner had a really interesting historical episodes he pointed to, and the title his posts was FDR's Immaculate Inflation. And he points to 1933 when FDR devalued the gold content of the dollar, but temporarily took it off gold and re-valued it at the much different rates so that there'd be more dollars created. And at that point in time, unemployment was near 25%. So by any reasonable understanding of slack in the economy, 25% unemployment would imply a huge output gap, lots of slack. And despite that, FDR's action engineered massive, [inaudible] temporary, but massive inflation in 1933, went above 20%. Now Scott's looking at the wholesale price index, but it goes above 20%, and that was due to the change in anticipated inflation.

Beckworth: So there was a case where it was very credible, very clear, and people began to freak out and unload their money balances, begin to spend them, turn them over because they knew prices were definitely going to be higher in the future. And this didn't have a lot of bearing on unemployment, at least immediately; I'm sure eventually it did.

Andolfatto: I missed that post I'm afraid to say; that sounds very fascinating. And I think that just speaks to how, as economists, have to remain humble in terms of the theories that we have to try to interpret the world. The world is very complicated, I mean, institutions vary over time within a country and there are different across the country. So we have to be very careful in resting on our laurels, and believing that we have a Phillips Curve theory of inflation, we can rely on this and not consider other possibilities.

Beckworth: Yeah, and I think it's fair. I'm sure Paul Krugman could push back against what I've just said. And I've had some people tell me personally they'd say, "Look, believe that money matters for inflation too David; we believe it. But it seems to matter more when you get to higher rates of inflation or higher rates of money growth. When you get down to these low values, it's a little unclear, a little hard to tease out clean causal relationships." And maybe that's fair, it's tough either way through a money view or a Phillips Curve view to pinpoint the exact parameters of the relationship. And [inaudible] like-

Andolfatto: That's weird, I've heard that before, I can understand where that's coming from. So nobody disputes the mechanisms I've been describing thee-

Beckworth: Yeah.

Andolfatto: Monetary fiscal mechanisms for understanding hyperinflations. And yet to somehow we have great trouble in trying to understand the very same mechanisms for understanding low inflations. And, unfortunately, our theories don't identify for us what is a high and a low inflation. I mean, why, why should theory break down at 5% inflation and not 500% inflation? It's not entirely clear.

Beckworth: No I agree with you. I think what they would say, maybe it's harder to measure it precisely at low levels; I'm not sure, I haven't pushed them hard back on that point. But I think there's [inaudible] a hyperinflation; maybe Venezuela's now is a great example. Because they're having massive runaway inflation, and I'm sure if there's a Phillips Curve in the country it has little bearing on what's happened-

Andolfatto: Exactly.

Beckworth: With inflation. And that a case is very clear where Phillips Curve is very, very misleading and not useful at all.

Andolfatto: I'd like to point out another fact too, is that ... I mean, Paul Krugman has written very well, very eloquently on the case of Japan for many decades now and the liquidity trap there and what it would take to get out of the liquidity trap, how to raise the rate of inflation. And he appeals to the very same forces that I'm appealing to in the monetary theory that I'm proposing. And so, in particular, he was not advocating for Japan to lower the unemployment rate to get their inflation rate up. He was advocating monetary fiscal expansion through permanent helicopter drops; so there's another example. I don't think that he and I actually disagree fundamentally on a lot of things, it kind of came across that way in his-

Beckworth: Yeah.

Andolfatto: Rebut, but-

Beckworth: Yeah I think you're right, I think that '98 paper, which I agree with too. In some ways that '98 paper's just invoking long-run quantity theory of money, which is really behind-

Andolfatto: Yes.

Beckworth: What we've been talking about today.

Andolfatto: Exactly.

Beckworth: And, in fact, Michael Woodford in his 2012 paper, Jackson Hole, where he goes over all the options at the zero lower bound, he talks about Krugman's paper, his own paper, some other papers that talk about the importance of permanent helicopter drops. He goes, "Really, this is just invoking the long run quantity theory." But what we recognize in these papers, it's really hard to do it credibly. It's really hard in an advanced economy, in these circumstances do credibly.

Andolfatto: Yes.

Beckworth: Let me throw at you a comment from your blog that I thought it was really interesting, and you had a great reply to this. So there is a commentator, he put his name down as Traditionalist. So if you're listening Traditionalist, here's recognizing your comment. But I loved your reply to this, I'm going to read what he said. And he was responding to what Paul Krugman had said, but he basically been echoing Paul Krugman's thoughts earlier prior to Paul Krugman's reply.

Beckworth: But after Paul Krugman said what he said, here's what he said. He goes, "I want to make it more general point. At close analog about Krugman's point, and that is that the effects of monetary policy that ignore the rule of short term nominal interest rate. A lot of monetarist bloggers like to criticize mainstream macro's focus on monetary policy via interest rates, arguing the interest rates are really just an epi-phenomenon, a distraction from the main mechanism.

Beckworth: But if you try to identify the mechanism, the actual decision making at the micro level, you realize that interest rates are absolutely crucial and, if anything, money is a distraction. The Fed has traditionally implemented monetary policy by intervening in obscure market that virtually no households or firms participate in. This only influences real behavior because it affects much more important interest rates via expectations and arbitrage, and these [inaudible] matter for decisions. You can't escape the central role of interest rates as a summary of what matters for household decisions, toy models can obfuscate it, but it's no accident rates are central to most larger scale models." So David, what do you say to traditionalists?

Response to Monetary Traditionalists

Andolfatto: Well what I say at a fundamental level, kind of what I am saying here in expositing this, you has to be true, because if it's not true, I think the government might have available one of the greatest free lunches of all time, and that's specifically ... If it is true, it is the unemployment rate being below the natural rate that generates inflation, and that monetary factors don't play a role, then there's an obvious policy conclusion here that the Fed should just basically set the nominal interest rate to zero.

Andolfatto: The fiscal authority should cut taxes and just finance everything by issuing zero interest rate treasuries. And because this is not going to have an inflationary consequence, this is going to be obviously a great free lunch for everybody. So that's kind of a silly kind of example, but what it serves the show is that sooner or later, I mean, the rate at which the government expands its supply of outside assets, I mean, it has to be inflationary at some point.

Beckworth: Right.

Andolfatto: And moreover, I don't have to invoke any immaculate inflation here. I mean, the mechanisms are ... The reason why I did not go into detail explaining the incentives, is because I just thought that it was by and large very well understood. I mean, you cut taxes, you finance a tax cut, or increase government spending, whatever and you finance it by printing money, households are going to spend their money not expecting taxes to be raised in the future. They feel wealthier, so they're going to go out and spend money; that's going to look like a positive aggregate demand shock, or the government increases government spending and finances it with printing new money; that's a positive aggregate demand shock.

Andolfatto: Of course, you got more money chasing fewer goods, this is a very well understood and very intuitive mechanism for getting the price level to start rising. So that's basically the nature of my response to that type of observation offered by Traditionalist.

Beckworth: There's a clever and funny one, there's that free lunch is print and buy up everything. Well let me through another response out to traditionalists, because he focused on interest rate as a summary indicator of household decisions. And there's a part, though, where he mentions the Fed does open market operations, and he says, "This only influences real behavior because it affects much more important interest rates, plural, the expectation and arbitrage, and these [inaudible] matter for decisions."

Beckworth: If you go back and look at Allan Meltzer and Karl Brunner’s work, where they really get into the Montrose transmission mechanism, they're very clear in pointing out that an open market operation works by affecting a spectrum of interest rate and asset prices, which is very much what Traditionalist is saying here. That money affects real balances, it affects portfolios, as I mentioned earlier. That rebalancing the portfolios across all assets affects all relative asset prices and interest rates. And that is really not that inconsistent with what Traditionalist is saying here. I think the real tragedy is that kind of new Keynesian models kind of show this, and kind of make it easy for us to be lazy, and think of monetary policy just in terms of a one interest rate. The short-term policy rate, or at least the expected path of the short term rate-

Andolfatto: Mm-hmm (affirmative)-

Beckworth: Relatively neutral rate. But I think it's fair to say the monitors, the old monitors understood it was a broad spectrum of assets, and households and firms that were rebalancing portfolios would affect them. So kind of going back to your point, I think there's actually some agreement here; we're maybe talking past each other sometimes.

Andolfatto: Yeah, I mean, I'm not going to disagree with that at all. But, in fact, I totally agree with it. But I'd also like to stress that I don't think that that type of thinking is necessarily inconsistent with kind of people who organize their thinking with new Keynesian models either. I mean, it's easy to ... The world is a complicated place, there's a lot of things going on at the-

Beckworth: Yeah.

Andolfatto: Same time. And it's a really a question of in our little simple models, which forces we want to emphasize? And sometimes you might want to emphasize certain forces, other times you want to emphasize others. But, on the whole, I think that what I take away from all of this is I actually think the amount of disagreement in macro is often very much exaggerated, that there's a lot we actually agree on. And the question is really often just a matter of which are these forces we think are quantitatively more important at different points in time.

Beckworth: Yeah. Going back to our earlier points about the demand for money, the demand for treasuries, and safe assets, it's going to be interesting to see what President Trump's budget deficit blowing actions are going to do to all of the this. Will the deficits create a big enough supply of treasuries to satiate the demand? You mentioned rates have gone up some, but they're still relatively low. Inflation-

Andolfatto: Right.

Beckworth: Still hasn't budged a whole lot. In fact-

Andolfatto: That's right.

Beckworth: This past month it was core PCE, I think it was 1.6; now it may take time to change. But it will be interesting, and I think from my perspective, it will be nice to get interest rates back up to normal levels like we had before. And I know there'll be a lot of probably pain in the transition, people's plans and budgets and government financing costs may might go with that, but it will be nice to see what happens. This is kind of a nice experiment, are we truly a full employment, and what will happen if we add all this new money to the economy? And it may shed some further light on this discussion we've been having today. Well, let's move through policy implication in the time we have left. What would you say to policymakers, people at the FOMC, what's the takeaway from this conversation?

Policy Implications

Andolfatto: Well the takeaway, I think, is to think about possibly a different way of thinking about the inflation process. I really ... It does, to be honest, irk me a little bit when I see headlines in the paper saying, "Central bankers don't understand what causes inflation, and they don't understand the low inflation." I think that that's true if, to the extent that you're wedded to particular version of the Phillips Curve. But I think in terms of policy advice, I'd say think more broadly, that there's other ways to think about what's driving inflation. You don't have to be so wedded to the Phillips Curve, you don't have to be, necessarily, that concerned about unemployment rate falling to 4.1% or even lower.

Andolfatto: That that, in of itself, is not necessarily something that's going to cause an inflation problem in the future. So to the extent that looking at a broader spectrum or viewpoints of what drives the inflation process, it could lead to a better monetary policy, it might lead to not raising rates too rapidly to kind of thwart an inflation that's not in the works. I think that's, basically, what I would say.

Beckworth: Okay.

Andolfatto: I should say that a lot of people on the FOMC kind of understand this what I'm saying. There's a lot of members who are concerned about moving too fast, and it's just a part of an ongoing debate; there's legitimate arguments that could be made both ways, so.

Beckworth: Yeah, Neel Kashkari has been on the show before, he's had some interesting things to say about this, He understands the intuition of the Phillips Curve and has said so. But he's called it faith based economics, or faith based policymaking because it has been very hard to use it, and his predictions haven't been fulfilled. And so he's kind of relying on, as you mentioned earlier, kind of databased analysis. What does the data actually say is happening? And he's been more cautious in raising rates because of that approach. Now one-

Andolfatto: Can I push back on that a little bit?

Beckworth: Sure.

Andolfatto: Because I think it's an important point. I agree with him that it's faith based, but I have to be completely honest that almost everything we do in economics has some degree of faith based. Even my own preferred interpretation is faith based, in the sense that I don't get to observe money demand directly. I can always appeal to ... It's the equivalent of the natural rate of unemployment in the Phillips Curve interpretation.

Beckworth: That's a fair point, yeah.

Andolfatto: In that there's a kind of a free parameter floating out there. And that what we have to do as economists, is kind of recognize that where the faith is lying. And this is why I want to say that both interpretations and, indeed, perhaps other interpretations should be taken on board. And that the role of policy, more generally, but monetary policy in particular, is try to search for policies that are kind of robust in the sense that they're likely to work well regardless of what the true underlying model is of the economy. And I think that, ultimately, is basically about the best we can do being wise policy makers.

Beckworth: Do you think it would help policymakers to simply, I'm going to say, abandon but-

Andolfatto: Mm-hmm (affirmative).

Beckworth: Kind of let go of Phillips Curve thinking, and they set inflation target, but do you think moving to like a price level target, or a nominal GDP level target where they focus on that would make their life any easier in this debate?

Andolfatto: That's a very good question. I know that many people are advocating moves in that direction and who knows what might happen under new Fed chair, Jerome Powell? I'm not so sure, to be quite honest. I think it would take a lot more thought than I've devoted to this subject to see whether or not it would make life easier. I think that it may very well make life easier along some dimension. I think you're a big advocate, for example, of nominal GDP targeting Scott Sumner as well as others.

Beckworth: Yes.

Andolfatto: I remain agnostic on that. I'd like to ... For the time being, I haven't really given that too much thought because, for the time being, I've kind of realized that we're going to continue operating in the framework we're operating in. But it would be very interesting to think about that question.

Beckworth: Yeah, so I'll just mention my thinking on that. So whether it's a price level target, or nominal GDP level target, I can imagine a world ... And let's just say price level target, because I think that's actually getting more discussion right now. Let's say the Fed adopted a price level target, it could really just adjust its interest rates, whatever tool it's using, interest rates most likely, and look at the forecast of the price level. Let me look at current values the price level, without having to worry about Phillips Curves, natural rate of unemployment.

Beckworth: I know they're worried about things seeping up on them, or inflation suddenly surging. But I think the Fed could adopt a price level target, use asset prices, use breakevens. And I think they could make their life a whole lot easier just kind of adjusting their instrument, looking to their target, and looking at intermediate indicators that would help them see where they're going. But that's my monetarist vision of the world, and I know it's not gonna happen anytime soon. But our time is up, our guest today has been David Andolfatto. David, thank you so much for coming on the show.

Andolfatto: Thanks very much, David, that was a lot of fun.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.