VIA Modeled Behavior, I see that Arnold Kling has written a post which reads:

Mainstream macro in the 1970s (which a lot of people seem to have gone back to) held that there was a NAIRU, meaning the non-accelerating inflation rate of unemployment. If unemployment was above that, inflation would fall. If it was below that, inflation would increase. So, policy should shoot for the NAIRU. These days, unemployment is 8.3 percent, and inflation is increasing. Just sayin'.

Just sayin'...what, exactly? Don't imply, man, argue! Follow the point through to its conclusion and see if it actually holds together! Since Mr Kling didn't, I'll do it for him.

The NAIRU, as Mr Kling notes, is the non-accelerating inflation rate of unemployment. It corresponds to maximum structural employment; the economy can't sustain a higher level of employment than this without structural reform of some kind. Why is it called the non-accelerating inflation rate? Well, were the government to try to raise employment above that level, fiscally or monetarily, inflation would accelerate. Stimulus would raise demand for goods and services, which would lead to higher prices. Individual firms might respond to higher prices with increased production, by using higher wages to attract employees from other firms, but since there is no surplus labour at the economy-wide level, overall production can't undergo a sustainble increase in output. Instead, price increases trigger higher wage demands (which firms must accommodate given the lack of surplus labour), and higher wages trigger price increases. Expectations begin to adjust to take into account this dynamic; firms build in larger price increases to take into account probable future wage rises, and workers build in larger wage demands to take into account probable future price increases. Inflation accelerates, and to prevent economic disaster the government must tighten policy to reduce labour and product demand back to the economy's potential and re-establish inflation expectations at a steady level.

Got that? Now, Mr Kling says that according to this theory a rate of unemployment below NAIRU will trigger an increase in inflation. He then observes that with 8.3% unemployment, inflation is increasing. And he deploys the just sayin' line to imply that the economy is therefore below NAIRU—that is, at structural full employment, suggesting that further demand stimulus is undesirable. He is wrong on multiple levels.

First, it's very difficult to discern a steady increase, to say nothing of acceleration, in the inflation figures. Mr Kling points to a Calculated Risk post which discusses the Cleveland Fed's latest inflation analysis. That analysis notes that core consumer prices rose 0.2% in January. In 4 of the last 6 months, core consumer prices rose by 0.2%. Median CPI rose 0.2% in January. That is the same rate of increase observed in December, November, October, and September. In August, median CPI rose 0.3%. Inflation is positive and has risen on some measures. On others, however, it has declined. Perhaps most importantly, it is difficult to impossible to discern accelerating growth in wages, which is the most relevant price in this dynamic. Indeed, wages seem to be rising more slowly than prices generally. That translates into a relative reduction in real wages which is likely to encourage firms to draw more of the existing stock of surplus labour into employment.

But let's take a step back. A mainstream saltwater economist, of the sort Mr Kling would seem to distrust, would probably characterise the present economy in the following way. Slow growth and high unemployment indicate a problem, the most likely solution to which is looser monetary policy. In particular, it seems probable that the market-clearing real interest rate is below the actual interest rate, and if the central bank were to reduce its interest rate then full employment would soon be restored. Since the central bank's interest rate is close to zero, however, we have to assume that the market-clearing real interest rate is negative. To reduce the central bank's real policy rate further would require an increase in inflation. And from this we can generate a simple, testable prediction: if the central bank succeeds in raising inflation expectations, then it will move the policy rate closer to the market-clearing real interest rate, and unemployment should fall.

How does the real world match up against this simple model? Well, in August, short-term inflation expectations (as measured by 2-year breakevens) dropped below 1%. The real interest rate, as computed by the Cleveland Fed, sat above -1%. And the unemployment rate was 9.1%. In August, the Fed introduced language suggesting that short-term rates would be at exceptionally low levels through 2013. Inflation expectations began rising and were comfortably above 1.5% by early 2012. The real interest rate dropped, falling to -1.75% by December of last year. And unemployment has since fallen by nearly a percentage point.

Based on this, it seems reasonable to conclude that the Fed raised expectations which therefore encouraged more hiring. And it appears, based on the absence of accelerating inflation—and especially wage inflation—that this hiring has merely drawn workers out of a substantial pool of surplus labour. Mr Kling appears to have gotten both the diagnosis and the direction of causation wrong. And before we begin asking the central bank to engineer a rise in surplus labour, I'd hope to see substantially more proof that America is reaching the structural limits to increased employment.

One other point: Mr Kling updates his post with a quote from another blogger:

...if the economy is operating significantly below potential, inflation should have negative acceleration into a deflationary environment. However the two measures have diverged recently, indicating that the slack in the economy may not be that great.

It has been clear for some time that this is not the way modern economies work; we don't observe accelerating deflation. There is a very useful literature on persistent, large output gaps that describes the actual dynamics. Here, for instance, is an IMF paper on the subject:

This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices. Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.

The data match up very, very well with a story of a large and persistent American output gap. I don't really know why folks are so anxious to see something else in the numbers.