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.

5 comments
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Sunday ~ February 19th, 2012 at 8:07 am
bill woolsey
Other prices fall, or at least rise more slowly.
Sunday ~ February 19th, 2012 at 8:09 am
Curt Doolittle
Excellent. Now, look for twenty five policies using the same kind of logic and you can be certified as a right and proper neo-classical liberal master of PSST micro, rather than a creaky Progressive Keynesian Monetarist.
Seriously. Great post. We’ll get you a top three newspaper sooner or later.
Curt
Sunday ~ February 19th, 2012 at 12:38 pm
David Pearson
Great post. The Chicago Fed just had a paper out showing how Michigan Survey inflation expectations are back to 4%, but nominal income expectations fell from 4% to 2% during the Great Recession. This speaks to your “tightness in energy markets” argument. The more the Fed produces that “jolt” of inflation, the more consumer real income expectations fall, and with it demand and employment. Its not clear that the increase in employment created by more multi-family housing construction would offset the lower real income expectations created by higher rents. In general, economists seem to believe that the income effects of higher employment ALWAYS offset those from lower future real income growth expectations (which depress current spending). I’m not sure where they got that idea…
Sunday ~ February 19th, 2012 at 3:02 pm
rjs
as always, your theories miss the same key point…people can no longer afford it…
America’s Poorest People Running Out Of Places To Live: Study -. In every state in the country, there are people looking for cheap rental housing — and in every state, there aren’t enough units available, according to a report released Wednesday by the National Low Income Housing Coalition, a nonprofit organization. “The existence of the gap is not a matter of debate,” the report notes. The findings highlight the increasingly desperate situation of people who work but don’t earn much, and who are finding themselves priced out of the rental market as more and more Americans look for alternatives to traditional homeownership. For every 100 households that earn less than one-third of the median income for their region, according to the report, there are only 30 affordable and available rental units — meaning, places to live that aren’t dilapidated, prohibitively expensive, too far from public transportation, or already occupied by someone earning a higher salary.
http://www.huffingtonpost.com/2012/02/16/affordable-rentals_n_1282519.html?ref=business
until you get people back to work at a decent wage, nothing else you theorize will fly…
Friday ~ February 24th, 2012 at 11:12 am
dwb
no, it depends in supply or demand side inflation. SRAS is inelastic in the short term so higher demand leads to higher supply side prices (gasoline, housing). If wages are rising slower than prices, thats a sign of supply side inflation (generally, Q increasing and P increasing). Prices will eventually revert as capital projects are completed. Supply-side issues are constraining the rental and housing market (the hopefully-massive influx of vacant REOs into the rental market should help to contain rental increases – which are driving up “housing inflation” even though home prices are down 35% and mortgage rates are low)
If wages are rising faster THATs wage or cost-push inflation. The Fed IMO should not be reacting to supply-side inflation. Eventually prices revert as projects are completed.