Kill the NAIRU

For decades economists have decreed that inflation can only be kept in check if the unemployment rate is above 5 per cent. This theory is now falling apart.

With any luck 2015 will finally see the death of the NAIRU, the acronym that has produced more misery in the past 50 years than any other.

It stands for the non-accelerating inflation rate of unemployment and refers to the idea that there is a level of unemployment below which wages and prices will start to rise, so that interest rates have to be hiked to get unemployment back up.

Ever since Kiwi economist Bill Phillips plotted British unemployment against inflation in 1958 and invented the Phillips Curve, the relationship between price stability and a whole lot of people being out of work has been a pillar of economic theory and central banking practice.

The so-called dual mandate of most central banks – full employment and price stability – is actually regarded as a theoretical impossibility; or rather “full employment” is another way of saying “NAIRU”.

In other words, for 50 years or so our economic betters have decreed that inflation can only be kept under control, and the value of money preserved, if a lot of people don’t have a job. And they have gone about ensuring that that is the case.

The other theory about inflation, the one put forward by Milton Friedman, is that it is “always and everywhere” about money: the more money there is, the more inflation.

Well, both of those theories are now falling apart. Friday’s employment data in the US saw unemployment fall from 5.8 per cent to 5.6 per cent but hourly wages actually fell.

And of course the Federal Reserve has materialised more than $US3 trillion of fresh money since 2008, yet inflation is still falling. When the US CPI is released on Friday it is expected to show that consumer prices fell in December.

Most of that comes from the 50 per cent collapse in the oil price, of course, but wages growth is not inflationary either, even though unemployment is falling.

Despite all this, economists are still churning out reports that link the next increase in interest rates to the level of unemployment (they’ve given up equating it to money supply – that’s a dead duck).

So what IS the non-accelerating inflation rate of unemployment? Well, according to the US Congressional Budget Office, which calculates it regularly, it’s … well, it’s 5.7 per cent – above the current US unemployment rate.

But actually it’s a moving target, fluctuating between 5 per cent and 6 per cent since 1950. That is, at least 5 per cent of the workforce always needs to be unemployed for prices to be stable.

What rubbish. I read a report yesterday from the economists at Societe Generale that the NAIRU is "generally thought to be between 5.25 – 5.5 per cent, which will be reached by late winter/early spring. By that time, we should see at least budding evidence of wage pressures".

Or not. Human jobs are being replaced by machines and software algorithms at an accelerating rate, so pay rises are very hard to come by these days, and will be for a while.

On top of that cloud computing and other technologies are reducing non-labour costs and making labour more productive.

At the same time, tough competition is forcing firms to pass on their cost reductions in lower prices to maintain market share.

By the way, that’s what’s going on in the oil market: OPEC is attempting to hold market share against competition from the American shale producers, and the price has collapsed as a result of a price war.

That’s not to say inflation is dead. But it’s definitely in a coma, on monetary life support, with most central banks printing money and holding interest rates at near zero to try to get average prices to go up instead of down.

Their concern is deflation, not inflation. So maybe someone should take the NAIRU out the back and strangle it, and start thinking about actual full employment instead of 5 per cent.

They might not achieve it, but you never know unless you try.