Kocherlakota On Negative Supply Shocks

Includes: RINF
by: Scott Sumner

Marcus Nunes directed me to an article by Narayana Kocherlakota, discussing the impact of negative supply shocks:

Let's consider three ideas that have been popular on the campaign trail.

  • Increasing the minimum wage. What if Congress decided to increase the federal minimum wage by 10 percent a year over the next five years? Typically, economists would be concerned about the impact on employment: Higher wages might lead businesses to employ fewer workers. With monetary policy out of the picture, though, the move might actually help. The expectation of higher wages would cause consumers to expect more inflation over the next few years, leading them to buy more goods and services now, before prices went up. To meet this added demand, businesses would have to boost production and hiring.
  • Increasing import tariffs. Suppose Congress gradually raised tariffs on imported intermediate goods, such as steel and sugar. Economists would worry that this would reduce the benefits of free trade. But as long as the Fed didn't respond by raising interest rates, there would also be a positive effect: Households would expect higher prices, which would again prompt them to demand more goods and services today - creating much-needed demand for businesses.
  • Imposing restrictions on immigration. Most economists would oppose such a move, because immigration is seen as an important contributor to overall growth. Yet again, though, the logic changes somewhat if inflation is too low and the Fed is passive. Households might expect the relative scarcity of labor to drive up wages and prices, triggering purchases that would benefit businesses and the economy more broadly.

The Fed's response is crucial in all these cases. Typically, the central bank reacts to increases in inflation by raising interest rates sharply - a move that would choke off any demand that the policy measures might generate. With inflation running well below target, however, it's appropriate for the Fed to hold rates low even if it sees a modest increase in inflationary pressures. It's this subdued reaction function that allows the policy initiatives to have more positive effects.

I find this peculiar, for a number or reasons. First, I doubt that any demand-side effects of negative supply shocks would overcome the negative supply-side effects of these policies. Second, I deny that these policies would boost demand, even at the zero bound. Higher minimum wages will lead to expectations of lower profits, and this will reduce investment. What makes corporations invest more is higher expected NGDP. What makes firms build more houses, is more immigration. The crackdown on immigration in 2006 slowed the housing boom.

If you prefer Keynesian language, negative supply shocks reduce the Wicksellian equilibrium interest rate, making the "zero bound" problem worse. Low immigration is exactly why the zero bound problem is most severe in Japan, and high rates of immigration is one reason why Australia never even hit the zero bound. Fast NGDP growth leads to higher nominal interest rates, and no zero bound problem.

So even at the zero bound these policies do not work, as we found out when FDR raised wages sharply in July 1933, aborting a robust recovery in industrial production. But it's far worse. We are not at the zero bound, and hence the Fed would simply raise rates to neutralize the effect on inflation. Kocherlakota writes the final paragraph in a way that almost seems to suggest the Fed agrees with him, and would react the way he wishes. But clearly they would not, or the Fed would not have raised rates in December. So it's a moot point. Elsewhere, Kocherlakota says:

The Federal Reserve faces a big challenge: It wants to get inflation up to its 2-percent target, but so far its stimulus efforts have failed to reach that goal.

That's simply inaccurate, for reasons that Kocherlakota has himself explained numerous times. The Fed raised rates in December over Kocherlakota's (wise) objections. That means the Fed does not share Kocherlakota's inflation objectives, or else they think they've already succeeded in the sense that expected future inflation is 2%. But either interpretation is inconsistent with Kocherlakota's "tried and failed" suggestion. Either they are not trying, or they think they've succeeded. Take you pick, there are no other plausible options.

In fact, these initiatives would tend to reduce NGDP growth, as monetary policy would tighten to prevent any increase in inflation, thus reducing real GDP growth. Because wages are sticky, lower NGDP growth would boost unemployment. And in the case of higher minimum wages, the unemployment effect would be especially large.

The fact that even a dove like Janet Yellen is aggressively raising interest rates to keep inflation from exceeding the Fed's two percent target is a shot across the bow to progressives. Yellen is essentially saying; "You go ahead and raise wages to $15/hour. But we aren't going to allow higher inflation. Instead, we'll raise interest rates enough to create lots more unemployment."