Is the natural rate hypothesis dead? Maybe. Probably.

From the mid-1970s until just the other day, the overwhelming view in macroeconomics was that there is no long-run tradeoff between unemployment and inflation, that any attempt to hold unemployment below some level determined by structural factors would lead to ever-accelerating inflation. But the data haven’t supported that view for a while; and the latest US employment report, with its combination of a low reported unemployment rate and continuing weak wage growth, seems to have brought skepticism about the natural rate to critical mass.

But what does it mean to question or reject the concept of a natural rate? Reading Mike Konczal’s explanation for the layperson, or Olivier Blanchard’s exposition for the pros, I wonder whether the point is coming across clearly enough. That’s not to say that there’s anything wrong with either Konczal or Blanchard – I completely agree with what both are saying, except that I would take a stronger stand than Olivier against the old orthodoxy (which probably says more about our personalities than about our take on the evidence, which appears to be identical.) But I thought it might be useful to restate the case and the implications.

The bottom line here is that the case for aggressive monetary and, when necessary, fiscal policies to sustain demand is much stronger than we used to think. Errors like the turn to austerity and the ECB’s 2011 rate hike were much bigger mistakes than the previous doctrine allowed for; premature Fed rate hikes would be a bigger sin than even the Fed seems to realize now. For given what we now seem to know, output lost to weak demand is lost forever; there is no chance to make up for it later.

During the 1970s almost the whole macroeconomics profession was persuaded by the experience of stagflation that Milton Friedman (and Edmund Phelps) were right: there is no long run tradeoff between inflation and unemployment. Current inflation does depend on unemployment, but it also depends one-for-one on expected inflation:

Inflation = f(U) + expected inflation

where f(U) means some function of the unemployment rate. Meanwhile, expected inflation presumably reflects past inflation. So trying to keep U very low means raising inflation ever higher to keep ahead of expectations, which is not a sustainable strategy.