Climateer Investing: Questions Americans Want Answered: "Is it time to ditch the natural rate hypothesis?"

Sunday, January 7, 2018

Questions Americans Want Answered: "Is it time to ditch the natural rate hypothesis?"

From Real World Economics Review, Malmö U's own, Professor Lars Pålsson Syll:

Fifty years ago Milton Friedman wrote an (in)famous article arguing that (1) the natural rate of unemployment was independent of monetary policy, and (2) trying to keep the unemployment rate below the natural rate would only give rise to higher and higher inflation.

The hypothesis has always been controversial, and much theoretical and empirical work has questioned the real-world relevance of the ideas that unemployment really is independent of monetary policy and that there is no long-run trade-off between inflation and unemployment.
Although Olivier Blanchard also has his doubts — after having played around with a ‘toy model’ and looked at the data — he lands on the following advice:

Failure of either of the hypothesis leads to a more attractive trade-off between output and inflation, and, in the presence of shocks, suggests a stronger role for stabilization policy. If the independence hypothesis fails, adverse shocks are more costly, and stabilization policy more powerful. If the accelerationist hypothesis fails, there is more room for stabilization policy to be used at little inflation cost.

Where does this leave us? It would be good to have a sense of … the specific channels at work. The empirical part of this paper has shown that we are still far from it. Thus, the general advice must be that central banks should keep the natural rate hypothesis (extended to mean positive but low values of b and a) as their baseline, but keep an open mind and put some weight on the alternatives. For example, given the evidence on labor force participation and on the stickiness of inflation expectations presented earlier, I believe that there is a strong case, although not an overwhelming case, to allow U.S. output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.
My own view on the subject is that the natural rate hypothesis does not hold water simply because the relations it describes have never actually existed.

The only thing that amazes yours truly is that although this is pretty ‘common knowledge,’ so-called ‘New Keynesian’ macroeconomists still today use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why?...