Nathan Sussman, professor at the Hebrew University, former Director of the Research Department and member of the Monetary Policy Committee at the Bank of Israel, gave an interview to Balázs Vonnák after his lecture at a course of the MNB Department (Theoretical and practical challenges in monetary policy). He shared his views on global Phillips curve, dynamics of inflation expectations, challenges of monetary policy and the role of inequality in economic growth.
Balázs Vonnák (BV): In a very interesting paper you have presented at the Corvinus University of Budapest, you and your co-author find that the slope of the global Phillips curve has increased, meaning that changes in demand have bigger effect on inflation. How could it be reconciled with other studies claiming that the Phillips curve has become flatter?
Nathan Sussman (NS): In our paper we tested for a global Phillips curve that captures the global relationship between inflation and the output gap. While this does not rule out that in specific economies the curve became flatter, we cite studies, mainly from the Eurozone, that have arrived at similar results. The observations on the flat Phillips curve are motivated by the very recent past when unemployment declined but inflation did not pick up as expected. However, not so long ago inflation declined quite rapidly, even into negative territory, between 2014 and 2016 which is not consistent with the flat Phillips curve hypothesis. The recent decline in unemployment in many economies is reflected in strong nominal wage growth which is line with original wage-unemployment Phillips curve. The puzzle is why wage growth does not lead to higher inflation. Note, that the transformation from the original, wage-unemployment, specification to the inflation-unemployment Phillips curve assumes a constant markup of prices over wages. It could be that the recent rise in wages was coupled with declining markups due to increasing competition (supply side effect). This is also reflected in the rising of the labor share of income in output after a prolonged period of decline in many economies. The factors that are related to the steepening of the Phillips Curve, namely, increasing global competition in goods markets and increasing flexibility in labor markets are essentially positive supply side effects. These also lower the natural unemployment rate (rightwards shifts of the Phillips curve). A series of these positive effects could show up as lower unemployment for the same inflation rate and therefore be observationally equivalent to a ‘flat’ Phillips curve. Therefore, we have to witness a much longer period of rising wages before we can conclude that the Phillips curve has indeed flattened.
BV: What do your results tell about whether inflation expectations are anchored?
NS: The results we provide in our paper suggest that so far inflation expectations remain anchored. We define anchoring a la Blanchard, in the sense that expectations did not become more backward looking (adaptive) or more serially correlated. Our findings are consistent with an increased volatility of inflation expectations which does not necessarily imply un-anchoring (of the expected long term level). We have to keep in mind that the volatility we are capturing is very low relative to the period before inflation targeting. We also note that current inflation targeting monetary rules do not target volatility as such. Recent developments, which are outside the scope of our paper show that in 2015 and 2016 long term forward inflation rates fell below the 2 percent target. However, they have since recovered. However, central bankers are rightly concerned because the fact that inflation expectations remained forward looking, does not rule out a possibility that forward looking agents may lower the level of future long term inflation below that of the central bank.
BV: Is this a challenge for monetary policy to address? Do you think that inflation targeting is still a good framework?
NS: Monetary policy is indeed facing new challenges. The answer to whether increased volatility of inflation expectations is something that should concern monetary authorities is not simple. On the one hand if the long term inflation rate is anchored, then short term volatility becomes a noise that economic agents tend to discount when making medium to long term decisions. For example, economic agents have come to deal with exchange rate volatility. On the other hand, increased volatility in the short run may lead agents to believe that inflation is not anchored in the long run. The challenge is to convince the public that the central bank is committed to the long term inflation rate even though it cannot credibly commit to target short term volatility. Perhaps this requires policy intervention when volatility becomes excessively high – in a similar way to, the now accepted, exchange rate interventions. Of a greater concern is how to deal with the possibility of an increase in the slope of the Phillips curve? An increase in the slope of the Phillips curve causes small changes to monetary policy to have larger effects on the economy. In such an environment policy should be conducted with extreme care to avoid excessive volatility in the ‘real economy’. It is perhaps even more important to anchor longer term inflation in such an environment. Inflation targeting was very successful in achieving this goal when conventional monetary policy was used. Therefore, I think that as a framework for anchoring expectations inflation targeting is still very appealing. It seems though, that the major challenge to inflation targeting lies in the policy tools mix. I think that most central banks moved away from the traditional Taylor rule to some sort of a more flexible version with more policy tools employed. Should central banks move further away or revert to traditional policy? Our research shows that the choice of direction is largely dependent on the effectiveness of the direction chosen in anchoring inflation expectations.
BV: Do you think that bigger global competition calls for more coordination of national (monetary) policies?
NS: Increased global competition is essentially about lowering transaction costs in markets for various goods. Ultimately, if we achieve complete global factor-market mobility there is a strong transactions cost argument in favor of a single global currency and monetary authority. However, we are not there yet. At the time being, many monetary authorities in advanced and increasingly at lesser advanced economies, have already coordinated their monetary policies by choosing similar anchors to their inflation targets. The coordinated anchoring of inflation rates together with capital market integration and the increasing correlation of inflation rates among many countries originating from greater competition is reflected in the strong co-movement of monetary policy tools among various countries. Moreover, conditional on being well integrated in capital and goods markets, credible monetary authorities can exploit these developments to achieve the ‘global’ inflation target much faster and at a lower cost. At the same time, the inflation targeting framework also allows for countries to deviate in terms of the monetary policies to address country specific shocks without compromising the overall commitment to the common long term inflation rate.
BV: Last summer you said at a conference that growing inequality in Israel is a drag on productivity growth. What do you mean by that?
NS: My argument rests on the assumption that growth in labor productivity is essential for economic growth. Labor productivity, in turn, is a function of innate abilities and education. In Israel, there is a strong correlation between income inequality and educational inequality. The public school system in Israel is relatively underfunded and suffers from additional problems that are not necessarily related to the level of funding. Therefore, affluent parents, directly or through the municipalities that they live in, partially compensate for these shortcomings, while the poor do not. This exacerbates initial inequality and also affects future labor productivity and therefore future incomes and so forth and so on.
BV: Do you think that the problem of inequality is still ignored in mainstream economics, as claimed in the 33 theses of economics reformation?
NS: I think that inequality is not ignored and actually received much more visibility with the work of Piketty, Saez and others. More recently it was related to issues of solidarity and its effect on economic growth. As economists, we would like to say that inequality is a worthy issue of research to the extent that it affects the efficient allocation of resources. Moreover, to the extent we can think of channels by which inequality negatively affects the allocation of resources as pointed out above in the case of education (human capital), there remains a debate about the remedies. In particular, most remedies call for more government intervention and perhaps more taxation and income redistribution. Most economists would agree that these measures have a cost in terms of efficient resource allocation. Therefore, we are left with a cost-benefit analysis that so far did not produce a consensus among economists. This is exacerbated by the political economy inclinations of economists. Given the increasing, by historical standards, role of human capital in production and well-being and given that human capital can be enhanced by learning, more than ever in the past the issue of inequality could create negative externalities for economies. In the age of digital media inequality, perhaps, gives rise to less solidarity and increasing political fragmentation that affects growth. It is up for economic research to document these channels. But this is not enough. Economists should help, perhaps with interdisciplinary research, find cost effective ways (that do not necessarily imply greatly increasing public spending) to reduce inequality in human capital acquisition.
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