When to run the economy hot?

Former Fed Chair Janet Yellen has recently suggested it is a good time to run the US economy hot (in the short-run) underpinned by the argument that the further fall in unemployment rate didn’t drag the inflation up.

The justification behind this is that the Phillips curve appears to have become quite flat.  As a result, stronger demand need not drive up inflation by much – suggesting we have a situation where, even with relatively low unemployment, inflation expectations are strongly anchored. 

Why has Phillip’s curve flattened?

The flatness of the Phillip’s curve could have a number of reasons – which would have different implications for policy.

One possibility could be a mismeasurement of unemployment rate – for example those who are considered out of labour force should be taken into account for wage and price inflation. If there were strong opportunities to enter the labour force, willingness of these individuals to participate would positively impact inflation. This would suggest that the labour market is still not strong – and we should then act that way.

Another possibility for attenuated Philips curve is that during recessions employers are reluctant to cut wages of employees, so that during recovery the wage increase looks restrained and businesses rebuild their own corporate savings.

However, the key to her argument can be found at the start of the WSJ piece:

running the U.S. economy hot for a period to ensure moribund growth doesn’t become an entrenched feature of the business landscape


In this way the “flatter Phillip’s curve” represents self-reinforcing expectations by households and firms – and if the central bank doesn’t respond to this by “running the economy hot” weaker expectations of growth can become reinforcing, holding output and incomes below their true potential.

What does this mean?

Janet Yellen suggests running the economy hot. This means letting unemployment fall lower and motivating faster growth to boost consumer spending and business investment. 

This does mean inflation may move beyond its target level, but given the flatter Phillip’s curve such any such response should be smaller.

With central banks seen as “credible” and inflation expectations anchored, weak demand since the Global Financial Crisis could have led to hysteresis. Hysteresis refers to the persistence of an effect in aggregate, even once the cause of that effect has ceased to hold – this is most commonly viewed through unemployment but is a term that is used in a variety of contexts.

In the case of the macroeconomy, a willingness to accept lower growth in prices and output could reduce firms expectations of output growth, which in turn leads to lower investment and employment helping to generating an inferior – but stable – equilibrium.

So Yellen’s idea is that if we believe that hysteresis effect is still a key remaining issue in the economy, we should let the economy run hot in short-term at least to boost demand and lift expectations of nominal growth. If the economy has the capacity to produce at this level, then the expectations of higher output and price growth will also be self-reinforcing.

But … there is no free lunch

However, there is a caution to bear in mind.

Policymakers should understand the true relationship of the flattened Philips curve, to possibly detect what factors led it to the flattened relationship, so that in a state of the downturn, inflation doesn’t shoot up to the sky.

There might be the case that when unemployment stayed low persistently, it could cause a non-linear relationship between unemployment and inflation, so that when unemployment suddenly increased, it would increase inflation by proportionally and significantly high amount.

Asking whether output is lower due to hysterisis (and the existence of a coordination issue that has pushed us into a “Pareto Inferior” equilibrium – or one where everyone is worse off), or is due to structural factors (eg population aging, a slowdown in technological innovation, rising X-inefficiency due to excessive market power) is a key question when asking if running the economy hot makes sense.

If it is the former, a short period of allowing the economy to run hotter than the models would normally suggest would be fine – it would not generate inflation, and the Phillips curve (and inflation expectations) will not switch. If it is the later, we would be repeating the monetary policy mistakes of the 1970s and early 1980s when we misunderstood the Phillip’s curve and the proximate importance of structural shocks (in this case an oil price shock).