Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Does The Fed Need An Inflation Floor ?

Inflation and Unemployment Revisited

In their famous seminal paper of 1983, Barro and Gordon wrote that In a discretionary regime the monetary authority can print more money and create more inflation than people expect. The benefits from this surprise inflation may include expansions of economic activity and reductions in the real value of the government's nominal liabilities…/… the government (and the private agents) would value stimulative policy actions that lower the unemployment rate below its natural value. However, because people understand the policymaker's incentives, these types of surprises - and their resulting benefits - cannot arise systematically in equilibrium. People adjust their inflationary expectations in order to eliminate a consistent pattern of surprises. in equilibrium, the average rates of inflation and 'monetary growth -- and the corresponding costs of inflation - will be higher than otherwise. This paper was the basis for monetary policy rule adopted by many central banks throughout the 1980s and 1990s.

It may sound like Econ 101, but in the context of the Fed's failure to bring inflation back to its 2% target, it could explain part of the slow decline in unemployment. If inflation consistently undershoots the target while private agents still expect this target to be met, then the "equilibrium" will lead to a lower than expected unemployment rate.

At first glance, it should depend on the nature of the unemployment.

i. If there is Keynesian unemployment, then the undershooting of the inflation is not an issue: the lower than expected inflation will result in higher real wages that should spur demand and help reduce unemployment; but

ii. If the unemployment is more classical in nature (that is linked to the low profitability of businesses), a negative surprise on CPI would mean more pressure on corporate' margins and thus an increase (or an insufficient decline) in unemployment.

Given that the majority of Fed members consider that a high share of today's unemployment remains attributable to the lack of domestic demand, they may not be in a hurry to bring back inflation to 2%. Yet, the mention of an inflation floor during the latest press conference should not be seen only as a fear of deflation but also as a requirement for inflation to be in line with expectations for the job market to work properly: On having an inflation floor, that would be in addition to the guidance. We are discussing how we might clarify the guidance on the federal funds rate. That is certainly one possibility.

Empirics may explain why: the chart below tracks the one year change in the US unemployment rate (assuming a constant participation ratio) against the distance of PCE deflator and the 2% target. As can be seen, the rate of decline of the unemployment rate had almost stalled when inflation fell well below 2%.

This supports the view that the economy is suffering from Classical rather than Keynesian unemployment. The stability of households' inflation expectations over the last few years would clearly suggest that real wages were too high ex-post - a point of view hard to sustain while the share of profit in total GDP remains close to historical highs. In other words, it would mean that what the US economy needs right now is more labor market reforms and labor force training than more demand.

Yet, demand-led proponents could also state that the causality is opposite: low demand led to a slowdown in the pace of reduction in the unemployment rate which led, as a result, to a slower pace of inflation.

Bottom Line: even though the decline in unemployment dwindled during the period where inflation clearly undershot the Fed's PCE deflator target, this may not be enough to suggests that most of the US unemployment is "classic." Nonetheless, the lack of elasticity of inflation expectations to the cycle is proof that the Fed managed to anchor inflation expectations quite well in spite of the expansion of its balance sheet. Any failure to bring inflation back to 2% in the near term may thus be a threat to a further decline in unemployment, once most of the output gap has been bridged and the hurdle for unemployment decline will be on the supply rather than on the demand side. That is the reason why the Fed needs an inflation floor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.