I’m enjoying Matt Rognlie blogging at his new place. He just wrote a post about what should be the target of the inflation target, linking to this paper by Greg Mankiw and Ricardo Reis. So what should be a target of an inflation target? Rognlie:
- The more responsive a sector is to the business cycle, the more weight that sector’s price should receive in the stability price index.
- The greater the magnitude of idiosyncratic shocks in a sector, the less weight that sector’s price should receive in the stability price index.
- The more flexible a sector’s price, the less weight that sector’s price should receive in the stability price index.
- The more important a price is in the consumer price index, the less weight that sector’s price should receive in the stability price index.
Mankiw writes about his ideal target using that criterion and brought up an interesting historical story:
Our results suggest that a central bank that wants to achieve maximum stability of economic activity should give substantial weight to the growth in nominal wages when monitoring inflation…
An example of this phenomenon occurred in the United States during the second half of the 1990s. Here are the U.S. inflation rates as measured by the consumer price index and an index of compensation per hour:
Year CPI Wages
1995 2.8 2.1
1996 2.9 3.1
1997 2.3 3.0
1998 1.5 5.4
1999 2.2 4.4
2000 3.3 6.3
2001 2.8 5.8
Consider how a monetary policymaker in 1998 would have reacted to these data. Under conventional inflation targeting, inflation would have seemed very much in control, as the CPI inflation rate of 1.5 percent was the lowest in many years. By contrast, a policymaker trying to target a stability price index would have observed accelerating wage inflation. He would have reacted by slowing money growth and raising interest rates (a policy move that in fact occurred two years later). Would such attention to a stability price index have restrained the exuberance of the 1990s boom and avoided the recession that began the next decade? There is no way to know for sure, but the hypothesis is intriguing.
It’s things like this that make me worried about being creative with inflation targeting. No notable inflation in the economy and the only period of sustained wage growth in my lifetime – better get the central bank to choke that off immediately. Can some Republican officially propose “price stability and minimal wage growth” as the new dual mandate for the Fed?
There’s a story that goes around, Dean Baker loves to tell it, that Greenspan was under immense pressure from serious economists to raise rates when unemployment hit 5% in the late 1990s because inflation must be right around the corner. Unemployment was below a poorly-defined-empirically NAIRU, after all. Greenspan didn’t, unemployment went lower, there was no inflation and, say it with me, the United States experienced the only period of sustained wage growth I’ve seen in my years on this Earth. Here’s to some discretion with our targets and rules.
Chris Hayes mentioned this incident in his paper on the case for inflation:
The main competition to monetarism in the 1980s and 90s was not Keynesianism, which continued to fall out of favor, but a politically related but theoretically distinct theory, about the “non-accelerating inflation rate of unemployment” (NAIRU or natural rate for short). The natural rate partisans held that there was a “natural rate” of unemployment, the necessary amount of joblessness to allow labor markets to churn and function with maximal efficiency. If unemployment dropped below this boundary (generally believed to be somewhere in the neighborhood of 6 percent), inflation would spike. In the late 90s, the theory was put to the test. As unemployment dipped below 4 percent in the 1990s, panicked natural rate advocates urged the Fed to raise rates to stave off inflation. Greenspan, in possibly the single highlight of his tenure at the Fed, refused, and inflation remained at historic lows. So much for the natural rate.
Rortybomb 
What’s especially interesting about the timing of the wage growth is that it occurred in the context of a boom in stock prices, which would suggest an expectation of profit growth, which we often associate with wage “restraint” (or, at least, that increasing wages would come after the equity price increases, rather than before or simultaneously).
Is it just me, or is the phenomenon of wages growing faster than CPI also known as “real wage growth”? It seems odd for Mankiw to openly declare war on real wage growth, let alone for anyone else to follow suit.
Worrying about “wage inflation” during a 3 decade period where we’ve seen virtually none (save a short period respite from 95-2000) and outright wage deflation over the last 11 years, is like an Eskimo worrying about his air conditioner.
The end product of Mankiw’s proposal will be more perpetual asset bubbles and wage stagnation. Like Josh Biven’s said on the panel discussion on Monday, we can’t use the discount rate to target asset bubbles, especially when the bubbles are accompanied by labor market slack. Our economic “thinkers” should be focusing on what types of tools can be used to manage asset bubbles, not what tools/policy should be used to target a “wage inflation” that doesn’t exist
The real inflation target should be population growth. The money supply needs to keep up with an expanding population. We have a historicaly stable population growth at about 3.5% that is a good target for inflation. That means we have price stability and low inflation.
It’s precisely because the situation in the late 1990’s is so rare (“the only period of sustained wage growth in my lifetime”) that it should not be an important example in choosing a policy regime. One one occasion, a nominal wage target would have given the wrong result when the actual policy gave the right result. In every other case, a nominal wage target would have given the right result when the actual policy often (like right now, for example) gave the wrong one. You want to partly like it’s 1999, at the expense of spending the rest of our lives either preparing for the party or cleaning up after the party. Rather than having such a party, where real wages rise strongly for a little while, I’d like to have ordinary life in which wages aren’t stagnant or falling most of the time. I doubt the ability of monetary policy to have much impact on real wages in the long run anyhow, but if it does have such an impact, my guess is that wage targeting would result in more growth of real wages over the long run, compared to the policies that have actually been followed.