The Natural Rate Of Inflation Isn't Carved In Stone

In the debate about the Fed's recent rate hikes, we have heard a great deal about the "natural rate of unemployment." The concept, coined by economist Milton Friedman in 1968, is that there is a normal amount of unemployment; if the government tries through fiscal or monetary policy to reduce joblessness below its "natural" or equilibrium rate, the economy will just pay a price in inflation. That in turn will reduce investment and thus create higher unemployment later on. This claim is a variant on the usual mantra of Chicago-school economics: The economy is doing the best it can, so leave well enough alone.

The Federal Reserve has evidently concluded that the natural rate is something in excess of 6%. The Fed has raised interest rates four times during the past four months, on the premise that too much job creation would be inflationary. But there are two separate fallacies at work here, needlessly denying the economy job creation and growth.

First, as this column has argued (Apr. 11) and as BUSINESS WEEK explained in a cover story (May 16), there is a good deal of evidence the Fed is battling ghosts. At the present rates of growth and job creation, inflationary pressures are virtually flat. On the eve of the most recent rate hike, on May 17, the Labor Dept. reported that consumer prices in April increased just 0.1% and that the core inflation rate, which excludes food and energy prices (on grounds of volatility), actually fell.

MOVABLE BEAST. Second, the "natural rate of unemployment," if it exists at all, is anything but stable. It varies over time and place as a result of public policies as well as shifts in the private economy. As I have suggested, the erosion of labor's bargaining power, coupled with increased global competition and technological innovation, means the economy can run closer to full employment without courting wage or price increases.

Columbia University's Edmund S. Phelps examines unemployment by year and by country for 1955 to 1990 in his recent, influential book, Structural Slumps. His finding: "The equilibrium path of the unemployment rate always approaches the natural rate, as before. But something has been added. The natural rate moves!"

Most noneconomists, of course, would not find that a startling insight. Phelps aptly suggests that some policies, such as excessive payroll taxes, can raise the cost of taking on new labor and thus push the natural rate up. Other policies, such as wage subsidies, can push it down. Structural characteristics of the economy that Phelps doesn't emphasize, such as the degree of price competition, the state of technology, and the strength and strategy of unions, can also affect the point at which job creation begins to stimulate inflation. For example, unions in Scandinavia, though far stronger than those in the U.S., have long had a policy of limiting wage hikes to productivity increases. They pursue this seemingly anomalous strategy in order to hold down inflation and thus to allow the economy to run closer to full employment.

CUTS BOTH WAYS. Recent structural shifts in the natural rate of unemployment have cut simultaneously in opposite directions. In Europe, where unions, minimum wages, and social supports remain strong and payroll taxes are high, few new jobs have been generated. In the U.S., where payroll taxes are smaller, it seems likely that the natural rate is lower than Europe's to begin with. Moreover, the U.S. natural rate has fallen because labor bargaining power is much weaker, and, thanks to new technology and sources of supply, there are ample opportunities for customers to resist price increases.

Some economists nonetheless point to offsetting trends that have pushed the natural rate upward, even in the U.S. For example, the University of Chicago's Robert H. Topel and Harvard University's Martin S. Feldstein contend that the persistence of structural unemployment leads to a higher de facto natural unemployment rate. After a while, low-skill, hard-to-employ people become effectively unemployable, no matter how fast the economy grows. To stimulate the whole economy to the point where the least attractive 5% are "hireable," one must arguably overstimulate the rest of the economy.

This insight, although accurate as far as it goes, is the economic equivalent of shooting the economy's wounded. If, as Phelps finds, the natural rate of unemployment moves, then sensible policies can move it. Job-training policies can push the natural rate still lower, both by making the structurally unemployed into more attractive job candidates as well as by eliminating wage pressures that result from spot shortages of highly skilled workers. Changing the rules on overtime would lead to new hires rather than longer work weeks. Labor Secretary Robert B. Reich says: "Whatever the so-called natural rate of unemployment, given the structures we inherited, this Administration is determined to push it down."

A worthy goal, that. Despite Friedman and the Fed, the "natural" rate of unemployment is anything but natural. And enlightened public policy is anything but helpless.

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