Regional President Speech

Labor Markets and Monetary Policy March 3, 2011 Narayana Kocherlakota Federal Reserve Bank of Minneapolis Disclaimer I am speaking for myself today, and not for others in the Federal Reserve or on the Federal Open Market Committee. Basic Principle of Economic Policymaking Don’t use a knife as a screwdriver. • That is: Given a problem, use the appropriate policy tool for that problem. • What Problem Does Monetary Policy Solve? Economies have to adjust in response to macroeconomic shocks. • — like increases in oil prices or falls in asset prices Lesson from the 1970’s: Monetary policy cannot eliminate this adjustment • process. Primary role of monetary policy: offset impact of nominal rigidities. • What Are Nominal Rigidities? Broadly: Prices and inflation expectations adjust only sluggishly in response • to shocks. This sluggish adjustment can create misallocations of resources. • Appropriate monetary policy can mitigate these misallocations. • Thus, if demand is low because of nominal rigidities, then monetary policy • should be accommodative. (In this talk: monetary policy = interest rate policy, including recent LSAP.) • Monetary Policy and Unemployment When is monetary policy the right tool to lower high unemployment? • Define u to be unemployment rate in the absence of nominal rigidities. ∗ • — u is called many things: structural, natural, potential, etc. ... ∗ Offsetting nominal rigidities implies that monetary policy accommodation • should move with u u . t ∗t − Challenge for policymakers: u changes over time. ∗ • Two Questions about the Natural Rate What can we learn about u from the data on unemployment ∗ • and vacancies? What other data can provide supplementary information about u ? ∗ • Question 1: Information in Unemployment and Vacancies Starting point: In large part, unemployment is high because job creation • is low. Analyze sources of low job creation using Diamond-Mortensen-Pissarides • model. Main result: these data alone are not conclusive. • Possible that low job creation is due only to real factors (for example, UI • benefits). — That is, u may be nearly as high as u. ∗ Then: Current monetary policy is overly accommodative. • But it is also possible that nominal rigidities are playing a significant role. • That is, u may be much lower than u. ∗ • Then: Current level of accommodation is appropriate. • Question 2: Other Sources of Information? Answer to question 1: Aggregate u-v data aren’t sufficient to pin down • u . ∗ Second question: Are there other data that can be of use? • Yes: data in surveys and inflation. • This auxiliary information supports current level of accommodation. • A Point of Clarification My question: What is u NOW? ∗ • I’m not asking: What was u in December 2008? ∗ • Many reasons to think that u changes over time. ∗ • Policymakers need to know current (and future) u , not historical u . ∗ ∗ • Outline 1. Diamond-Mortensen-Pissarides (DMP) Model 2. Information in U-V Data 3. Other Sources of Information 4. Conclusions 1. DMP Model A firm pays a cost k to create a vacancy. • With some probability, vacancy attracts a qualified applicant. • Firm and applicant then bargain over the wage. • The Essential Model Element u Key model variable is the ratio . v • u Firm is more likely to attract a qualified applicant if is high. v • u Worker will accept lower wages if is high. v • Benefits of Job Creation in the DMP Model Firm pays cost k to create a vacancy. • Approximate formula for the firm’s benefit from that vacancy: • u (p z) constant v × − × Definition of Terms p is the worker’s expected productivity (net of taxes!). • z is the worker’s flow benefits of not working. • Intuition for the Formula u (p z) constant v × − × u Rises as rises because: v • — vacancies are likely to attract qualified applicants — applicants will accept low wages. Rises as p rises, because workers generate more output. • Falls as z rises, because firm needs to pay higher wages. • Puzzling Lack of Job Creation? In December 2007, u = 0.05 and v = 0.031 (JOLTS data). • In December 2010, u = 0.094 and v = 0.023. • u is 2.5 times higher in December 2010. v • Benefits of creating a job seem to have risen enormously. • Costs have probably not changed. • Why won’t firms create jobs, given these large benefits? • Answering this question will lead us to u . ∗ • 2. Information in U-V Data Aggregate Demand Shortfall Standard explanation is that demand is insufficient. • Firms believe that they can’t sell more than their current production ... • and so they don’t hire more workers. • Implicit: Firms can’t (or won’t?) cut prices to generate more demand. • "Insufficient demand" means prices aren’t adjusting effectively. • Nominal rigidities are generating low output and high unemployment. • In this case, u is much lower than u. ∗ • Other Sources of Low Job Creation Does the DMP model suggest other explanations for low job creation? • Return to the formula for benefits of job creation: • u (p z) constant v × − × u We’ve seen that rose by 2.5 times from 12/07 to 12/10. v • What about the other terms in the formula? • Changes in p (After-Tax Productivity) Why might p have fallen (relative to trend) since 2007? • Expected increases in taxes: • — federal and state; corporate, personal, sales Expected increases in input prices (like energy). • Changes in z (Benefits of Not Working) Why might z have risen (more than usual) since 2007? • — extensions in UI benefits Tentative Numbers Mortensen-Nagypal (2007, RED) set p = 1 and z = 0.73. • Suppose p fell by 10% and z rose by 0.05 in the past three years. • — technically: relative to trend. These are very large — but not entirely implausible — changes. • If p and z change like this, what happens to the benefits from job creation? • u (p z) constant v × − × u ( ) (p z) rises by only 11%. v • × − In this scenario: Nominal rigidities are much less significant. • Hence: u is not much lower than u. ∗ • Summary u (p z) constant v × − × u Since December 2007, ( ) has gone up 2.5 times. v • By itself, this increase suggests that nominal rigidities are constraining job • creation. — u is well below u. ∗ BUT: It is possible that p has fallen and z has risen. • p 0.1 and z 0.05 implies job creation benefits are only up 11%. • ↓ ↑ But then nominal rigidities are not constraining job creation much. • — u is nearly as high as u. ∗ Bottom Line Aggregate u-v data are inconclusive about u . ∗ • These data are inconclusive about appropriate level of monetary policy • accommodation. Labor Market Matching Efficiency Along with p and z, there is another factor that could increase u . ∗ • If labor market matching efficiency fell, then u would rise. ∗ • Definitionally: Labor market matching efficiency has declined if: • Firm’s probability of finding a qualified applicant is lower than is implied • u by the high value of . v DMP model (applied to u-v data) provides an estimate of the post-2007 • fall in labor market matching efficiency. Even when we add this estimate, the u-v data are consistent with a wide • range of possible u . ∗ u might be as low as 5.9% (if you think (p z) hasn’t changed). ∗ • − or u might be as high as 8.9% (if you think (p z) has fallen by 0.15). ∗ • − 3. Other Information? Policymakers need to know u to determine appropriate monetary policy. ∗ • The aggregate u-v data aren’t definitive about the magnitude of u . ∗ • Do policymakers have supplementary sources of information about u ? ∗ • Basic Intuition of Auxiliary Information u is low relative to u if nominal rigidities are keeping demand low. ∗ • We need information to detect state of demand. • Surveys Various surveys of businesses about impediments to job creation. • Reserve bank presidents ask businesspeople for causes of low job creation. • What I find: "insufficient demand" first — and then taxes/regulation. • Implication: u may have risen since December 2007, but u < u. ∗ ∗ • (Somewhat Crude) Inflation Heuristics If u u is high, then nominal rigidities are pushing demand down. ∗ • − That should be reflected in behavior of inflation. • Basic idea: Low demand puts downward pressure on inflation. • Exact impact depends on model of price-setting and expectations. • Older models: u u is high when π (inflation) is low relative to π . t ∗t t t 1 • − − e Newer models: u u is high when π is low relative to π . t ∗t t t+1 • − In second half of 2010: core PCE inflation was 0.5%. • Low compared with past core PCE inflation ... • and low compared with future core PCE inflation. • Both new and old models suggest u u is significantly positive. t ∗t • − 4. Conclusions Is high unemployment mainly due to nominal rigidities? • Or is it mainly due to other factors? • Aggregate data on unemployment/vacancies aren’t definitive. • But other data imply that u u is significantly positive. t ∗t • − My conclusion: • It is appropriate for monetary policy to be highly accommodative. • Future Policy? In the future: I expect both u and u to fall over time. t ∗t • When will the FOMC need to cut back on accommodation? • The FOMC will continue to re-evaluate as it gets new information. • I will be paying close attention to the behavior of core inflation. •

Narayana Kocherlakota (2011, March 2). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20110303_narayana_kocherlakota

@misc{wtfs_regional_speeche_20110303_narayana_kocherlakota,
  author = {Narayana Kocherlakota},
  title = {Regional President Speech},
  year = {2011},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20110303_narayana_kocherlakota},
  note = {Retrieved via When the Fed Speaks corpus}
}