Was it really Fed policy that ended high inflation?

The problem with monetary policy has recently been neatly summarized by US economist Jeremy Rudd: “Policymaking unfolds on a ‘darkling plain,’ and its practitioners – as well as those who seek to advocate an alternative course – will invariably be burdened by a highly imperfect understanding of how the economy works; noisy and revision-plagued data; and outcomes that cannot even be specified in advance, let alone be assigned a credible probability weight”.

All kinds of things happen at the same time as the Federal Reserve and other central banks change their policy rates. And this means that successes and failures of monetary policy may be attributed to it even though the real reason where other factors.

One of the key watershed moments of the last fifty years was the switch by central banks from managing the growth of monetary aggregates to targeting inflation directly and in particular managing inflation expectations so that a dangerous wage-price spiral like in the 1970s cannot take hold that easily.

But I have written before about the evidence that inflation expectations really don’t matter for inflation. In fact, as I have discussed here, we seem to have not much of a clue about what drives inflation to begin with. But don’t take my word for it. Jeremy Rudd has the following conclusions to offer in his latest paper: “Perhaps the most sobering fact, though, is how little practical benefit six decades’ worth of additional experience has provided us: Our understanding of how the economy works – as well as our ability to predict the effects of shocks and policy actions – is in my view no better today than it was in the 1960s”.

Now, let me shake your belief in managing inflation expectations as the key driver of monetary policy success some more. David Ratner and Jae Sim, two economists from the Federal Reserve, tried to figure out why the relationship between wage inflation and inflation has broken down since the 1970s. Since the 1980s we have witnessed this link become weaker and weaker with wage inflation having less and less influence on consumer price inflation.

Ratner and Sim argue that the Fed focusing on inflation expectations may not be the only driver of low inflation over the last four decades. In fact, the Fed’s emphasis on inflation expectation may not be that relevant to begin with. Instead, they show that the reduction in union power to negotiate wage increases may be the main driver of low inflation. The chart below shows the number of workdays lost each year due to strikes and core inflation. To remove short-term noise, I use my usual approach and show a 5-year moving average.

Workdays lost due to labour action in the UK and core inflation

Source: Bank of England, ONS

Core inflation rose after the Second World War as price controls were lifted and prices could adjust to free market levels. Once that effect was digested core inflation remained low until unions started to become more aggressive in their demands for higher wages and increased strike rates. The decline in core inflation in the 1980s coincides with the reduction in union influence under the Thatcher government.

A similar pattern can be observed in the United States with a post-WWII increase in core inflation as price controls are lifted. A reduction in core inflation before rising strike activity due to more aggressive labour action leads to a wage-price spiral and the high inflation of the 1970s. During the Reagan administration, just like under Thatcher in the UK, unions lost significant power and ever since we have low core inflation again.

Workdays lost due to labour action in the US and core inflation

Source: Bloomberg, US Department of Labor

Does that mean that it is the declining power of labour unions that leads to lower inflation and hence we don’t have to worry about persistent inflation in the coming decade? The paper by Ratner and Sim argues that this might be the case.

Obviously, it is too soon to abandon inflation targeting. In my view, it is not clear if the link between labour union strength and inflation is causal or if we are observing a strong correlation due to some other underlying factor. But this and other research show that underneath the surface of central bankers promoting a focus on inflation targeting, it is worth noting that among the people who actually do the work on inflation and monetary policy, the consensus is shifting away from inflation targeting as a meaningful policy tool.

To quote Jeremy Rudd once again: “In particular, we have no convincing evidence that this situation [of low inflation] came to be because inflation expectations became well anchored or because the Fed won its credibility as an inflation fighter, which suggests that invoking a need to ‘keep expectations anchored’ or to ‘restore inflation-fighting credibility’ does not provide an especially compelling justification for a proposed policy action”.

As I tend to say, we are at the beginning of a macro revolution and over the coming decade, I think most of what we today take as conventional wisdom in economics will be overturned.