Watching the Republican Presidential debate this week, at the Ronald Reagan library, I couldn't help being reminded of the famous Misery Index, and that moment in his debate with President Carter, when Reagan argued:
When he was a candidate in 1976, President Carter invented a thing he called the Misery Index. He added the rate of unemployment and the rate of inflation. And it came at that time to 12.5, under President Ford. And he said that no man with that size Misery Index had a right to seek re-election to the presidency. Today, by his own decision [sic], the Misery Index is in excess of 20%
https://youtu.be/...
The index itself was actually invented in the mid-1970s by economist Arthur Okun, a former chair of the CEA during the Johnson administration, who is most known for "Okun's law", the rule describing the relationship between unemployment and GDP (wherein typically, a 1% fall in unemployment equates to a about a 2% increase in GDP). Okun also can be credited for creating the now common technical definition of a recession as 2 consecutive quarters of negative growth.
Anyway, Okun's Misery Index, calculated by adding the unemployment rate (U3) to the year over year change in CPI-U, now stands at 5.3% (5.1 unemplyment + 0.2 inflation). It hasn't been this low since April 1956.
What really has had me thinking of Okun this week though, has been some of the discussion of the Federal Reserve's decision to hold off on increasing the Federal Funds rate. There seem to be many who don't understand much of the fundamentals of the debate, neither the real reasons the Fed might be considering rate hikes, nor the reasons why keeping nominal rates so low for an extended period might be a good idea.
For starters, as Okun would have understood, the trade off with rate hikes is going to be one between inflation and unemployment.
The basic theory is that there is some interest rate (called the "natural rate" of interest) at which markets will clear, at which supply will equal demand, and there will be just enough jobs for everyone. Too much demand, too many jobs, and a shortage of workers, and you would get inflation as wages increase. Too little demand, too few jobs, and you would have unemployed workers and less than optimal production.
Now in practice, there are always some inefficiencies in labor markets which make it impossible to actually achieve "full employment" through macroeconomic policy alone, and instead you start to get inflation at a level of unemployment somewhat higher than zero. This level has thus been dubbed NAIRU, the "non-accelerating inflation rate of unemployment", and the goal of fiscal and monetary policy is generally to get as near as possible to that level, so that employment is maximized while inflation remains under control.
So where are we today? As Paul Krugman pointed out on Friday, estimates of NAIRU have seen a steady decline, as signs of any inflation have failed to materialize. And on the same day, conservative economist John Cochrane has an interesting post noting that low rates right now are not causing any of the imbalances or credit bubbles that most people would expect if rates were too low:
If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates.... The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.
That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.
If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.
So why does it look like rates are high, even when nominal rates are low? It's because the natural rate of interest is so low. This is exactly what Keynesian economics says happens in a liquidity trap, and the truth is the economy is only now just emerging from a Keynesian liquidity trap.
This brings me to a paper Okun wrote in 1971, "The Mirage of Steady Inflation" (pdf). At the time, the economy seemed to be experiencing the opposite situation:
DEVELOPMENTS WITHIN THE ECONOMY and the profession in recent years have generated a marked swing toward pessimism in the appraisal of the tradeoff between inflation and unemployment. During the fifties and the sixties, a 4 percent unemployment rate was generally accepted as a target for full employment. At that time, it was expected that it might be accompanied by an inflation rate of 2 or, at most, 3 percent.' In contrast, some recent readings of the Phillips curve reported in this journal suggest that, under present circumstances, a 4 percent unemployment rate means as much as 5 percent inflation for the long run, while holding the inflation rate down to 2 percent would require an unemployment rate of 51/2 percent.
I won't go into Okun's full analysis here, but I do want to highlight one portion where he seems to anticipate to possibility of accelerating inflation, which would become a real problem later that decade:
Can a government that shifts its inflation tolerance level from 2 to 5 percent convince anyone that it will vigorously combat 8 percent inflation in the event of unforeseen excess demand or another unfavorable surprise in the Phillips curve? ...There are grounds for suspicion that the government's strategy is asymmetrical and will let the inflation rate accelerate over the long run, even though no accelerationist mechanism exists in the private economy.
If Okun's observation is correct though, and accelerating inflation expectations necessitated higher unemployment targets in the 1970s, then since the opposite is happening now, inflation expectations are decelerating, and keeping the natural interest rate low, then perhaps we can now go much lower with unemployment than conventional wisdom suggests. Even back in 2000, at the end of the Clinton recovery, when unemployment bottomed at about 4%, inflation only topped out at around 3.5%. And it is pretty clear that long term inflation expectations have continued to fall since then:
So there's a good chance the Fed could get away with holding off on interest rate hikes for some time. We may well be looking at a situation like the 1940s-1950s wherein low inflation, interest rates, and unemployment are all the norm. I'm thinking an unemployment target of 3.5% might even be realistic.