Monetary policy can address nominal rigidities, but should not seek to overcome standard economic adjustments
"Suppose that the cost of energy rises suddenly. This increase influences the economy through rather standard demand-and-supply forces. With higher input costs, firms cut back on production and demand less labor, creating higher unemployment. The first lesson from the modern macroeconomic research is that trying to use monetary policy to eliminate this increase in unemployment, generated by the firms’ natural market response to changes in input costs, leads to rates of inflation that are too high relative to the Federal Reserve’s price stability mandate.Core inflation is more informative than labor market data in setting monetary policy
But the modern macroeconomic research also emphasizes that this standard demand-and-supply story captures only part of the effects of the energy price shock. Implicitly, the standard story assumes that the fall in labor demand triggers an immediate fall in wages. This assumption is contradicted by considerable evidence that firms are often unwilling to cut wages by much in response to shocks. Since wages don’t fall sufficiently quickly in response to the change in energy prices, firms cut back even more on labor, and unemployment is even higher than would be implied by the standard demand-and-supply story.
The second lesson from the modern macroeconomic research is that accommodative monetary policy can offset this additional increase in unemployment, caused by sluggish wage adjustment, without generating unduly high inflation. Intuitively, the additional increase in unemployment occurs only because of the downward pressure on wages, which eventually manifests itself as downward pressure on prices of goods. Accommodative monetary policy is able to offset this increase in unemployment and keep inflation from being too low.
This story about the consequences of a change in energy prices is only an example, but its lessons apply much more generally. The impact of any macroeconomic shock can be divided into two components. One component is the effect of the natural demand and supply adjustments that would occur if prices and their expectations were to adjust continuously. Monetary policy cannot be used to offset this natural consequence of the shock without creating inflation that is either too high or too low. The other component is the consequence of what economists call nominal rigidities—the sluggish adjustment of prices (including wages, the price of labor) and price expectations. Monetary policy can be used to offset this latter component of the shock’s impact without creating undue pressures on inflation. The challenge for monetary policymakers is to figure out how to divide the observed movements in the unemployment rate into these two components."
"Is the unemployment rate high because of nominal rigidities, or is it high because of other factors? That is a central question that confronts monetary policymakers seeking to set the appropriate course of monetary policy. In this essay, I’ve argued that data on aggregate labor market variables like unemployment rates and vacancies are insufficient to reach a sharp answer. Other information, including survey responses and inflation data, suggests that nominal rigidities are having a substantial impact. This conclusion, combined with the low level of inflation itself, implies that it is appropriate for monetary policy to be highly accommodative—as indeed it was at the end of 2010.
As always, monetary policy will need to evolve in response to ongoing shocks and new information. But I suspect that information about aggregate labor market quantities like unemployment will remain—at best—a noisy indicator about the appropriate stance of policy. Instead, I will be paying close attention to the behavior of core inflation. As the preceding analysis suggests, the changes in this variable appear to provide critical information about the empirical relevance of nominal rigidities, and therefore about the appropriate stance of monetary policy."
In the August meeting of the Open Market Committee, Kocherlakota was one of three dissenters against announcing a policy that near-zero interest rates would continue for the next two years. For my post agreeing with his dissent and laying out how I see the evolution of monetary policy in recent years, see "Can Bernanke Unwind the Fed's Policies?"