• rmacculloch

The Costs of Inflation & Unemployment Compared

Kiwi politicians famously announced a "go hard - go early" approach to coronavirus in 2020-21. However, when it came to containing inflation the policy was "go soft - go late". Yes, our so-called "elimination policy" was never applied to inflation. As such, the Finance Minister and Reserve Bank Governor got us into the current mess. The position of this blog is that not going hard and early on inflation was a monumental mistake.

That being said, now that inflation is high, a new problem has presented itself - how quickly should our central bank try to get it under control? That question is also presently being asked in the US, where inflation has just hit over 9%. Americans are debating whether the US Fed should deliberately engineer a deep recession by sharply increasing interest rates to bring down inflation - or alternatively increase rates more timidly to return to price stability over a longer time horizon, with a view to mitigating the unemployment costs.

The best approach depends on knowing the costs of inflation compared to unemployment. On that note, the New York Times called me yesterday to talk about these costs which were estimated in a paper I recently wrote. Their article is reproduced here (the NY Times has it behind a paywall), and parts are reproduced below:

"A paper by three New Zealanders that’s forthcoming in the Journal of Money, Credit and Banking taps into results from the Gallup World Poll from 2005 to 2019, covering 1.5 million people in 141 nations. The poll includes questions about how people feel about their lives and current situations. The researchers correlate how people answered those questions with economic conditions at the time in each country. (An earlier version of the paper is available online.)

The findings are remarkable. People are nine to 13 times as likely to report sadness or physical pain in the short term when there’s been a one-percentage-point increase in the unemployment rate as when there’s been a one-percentage-point increase in the inflation rate. Similarly, an increase in unemployment is about six times as potent as an increase in inflation in lowering people’s self-assessments when they were asked a longer-term question about how they feel about their lives on a scale of zero to 10.

The Harvard economist [and Former US Treasury Secretary] Larry Summers, who has been saying that the US needs an extended period of higher unemployment to get inflation under control, told my colleague Ezra Klein that he takes no pleasure in the prescription. “I went into economics because I believe that by controlling recessions & preventing downturns, you could change livelihoods for millions of families,” Summers said. But, he added, failing to stop inflation now could cause problems down the road: “What we care about is not just the level of employment this year but the level of employment averaged over the next 10 years.”

Summers argument, then, is that by fighting inflation, the Fed is ultimately fighting unemployment as well. But economists who highlight the damage of high unemployment don’t buy it. MacCulloch said he agrees with Summers that the government should try to prevent inflation from getting started. “But once inflation has got away, as it has now in the U.S. and NZ as well, you’ve got a problem, and the problem is how to bring it down without a lot of damage,” he said. If the Fed causes a deep recession, he added, “the adverse well-being effects are so severe, it’s probably not justified.” Better to move slowly in hopes of achieving a “soft landing,” he said.