Commenting on the commentary about the output gap Arnold Kling says
Mainstream macro in the 1970s (which a lot of people seem to have gone back to) held that there was a NAIRU, meaning the non-accelerating inflation rate of unemployment. If unemployment was above that, inflation would fall. If it was below that, inflation would increase. So, policy should shoot for the NAIRU.
These days, unemployment is 8.3 percent, and inflation is increasing. Just sayin’.
Pointer from Mark Thoma.
[UPDATE: Along similar lines, a (the?) blogger at Sober Look writes,
if the economy is operating significantly below potential, inflation should have negative acceleration into a deflationary environment. However the two measures have diverged recently, indicating that the slack in the economy may not be that great.
Which was a wake up moment because if you asked me what the Fed had to do to bring down unemployment, my right off the cuff answer would be – tolerate a jolt of inflation.
Not, because of any macro time series, but simply because of the raw fact that a booming economy is about to make both the energy markets and perhaps more importantly, the rental market really, really, tight.
Even if you only care about Core PCE, you are about to see core PCE take off as rents must rise. They must rise because the rate they are at is only consistent with a depressed economy.
In short, if the economy were better household formation would pickup. But, if household formation picked up, there wouldn’t be enough places to live. Which in turn would mean rents would pick up sharply.
This would soon be alleviated by a boom in apartment building which would drag employment further down and eventually drag down rents.
However, to break through this level of unemployment one would have to tolerate high rents for at least 18 months or so.
Which takes me back to Larry Ball on Hysteresis in Unemployment
The second broad issue is the nature of hysteresis. Through what mechanisms do short-run unemployment movements influence the NAIRU? What determines the strength of these effects in different countries and time periods? What are the implications for monetary policy?
My discussion of these topics is speculative. In my view, it’s clear that some form of hysteresis exists, but it’s not clear why. The relationships among unemployment, the natural rate, and inflation appear to be non-linear, but it’s hard to pin down the non-linearities precisely. As a result, policy implications are not crisp.
Well here we have a mechanism. And, its not a – can we explain non-linearities in the relationship between unemployment and inflation. It’s a straight-up, look if you do something that will decrease unemployment its going to result in a temporary rise in one large set of prices because that the only way we can make this thing work.
If the Fed responds to that by raising rates, that’s not going to do anything do address the underlying problem. Indeed, its only going to make it worse as you will have even more household dislocation and even fewer apartments.
You have to tolerate the rent increases. I don’t see another way to get kids out of the their parents basements.