Dear Ms Yellen: Raise the inflation target

Dear Ms Yellen:

Congratulations on both your appointment as well as becoming the first woman to head the Federal Reserve. This will potentially make you, at times, the most powerful and important person in the world.

We are more alike than one may assume on the surface. It’s not just that we both like economics, that we were both born at the vanguard of our respective generations (you the Boomers, me the Millennials), or that our fathers were men of science and mothers teachers. Being amongst the first of our generations grants us some perspective on what the mass of humanity which is poised to follow will do, how they may act, spend, and impact the economy. Both of us came of age in a decade of great economic turbulence, and a growing cynicism on the efficacy of public institutions.

Most importantly, you witnessed the largest and richest generation in history come of age, join the labour force, form households, and have children of their own. I am witnessing, at the least, the largest generation — that of your children — in history come of age. The reason I believe this to be significant is that the quantity of the population in this age group (let’s call them the young age cohort) is strongly correlated with inflation. When there is a surfeit of young, household-forming aged people, there has been proportionately heightened inflation.

We each lived through the deepest recession since the Great Depression at roughly the same age, with our slightly younger generational siblings (aged 20-24) suffering an unemployment rate above 16%. The cost to my generation from the past recession is already high. On top of very high unemployment, we have experienced delayed entry into the labour force, deferred forming our own households, and the development of all facets of our lives retarded by the economy running so far below potential. Fixing this output gap, I imagine, is the top priority of the Federal Reserve right now, and there is no doubt that we are making headway. The record 17.2% unemployment of the aforementioned aged 20-24 group has declined to 11.1%.

I write you not only to congratulate you on your appointment, but also warn you of a coming inflation pressure, and petition you to raise the inflation target. No, I am not talking about the contentious unconventional policies the Fed adopted to combat the Great Financial Crisis. The Fed has demonstrated its capability and facility in managing them, and have evidenced their ability to wind them down as appropriate. Instead, I refer to a demographic argument that inflation is strongly related to the size of the young age cohort.

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Figure 1: Black: year-over-year inflation (fraction) Orange: Model estimate based on population growth of 16-24 years age cohort

You acknowledged the Federal Reserve should not necessarily over-emphasize price stability over unemployment in 1995 [1] by stating, “to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” The scenario to which you directly referred were the oil supply shocks of the 70’s, but inflation also ran well above 2% in the 80’s – averaging 5.6%. Even after the supply shock ended and energy inflation’s impact on prices was over, inflation averaged 3.6% from 1983 through the end of 1989.

There are, I’m sure you will agree, many things you can attribute as factors to inflation. At its most basic level, inflation simply means that demand is advancing into a upwardly sloping supply curve. But that definition struggles to really pictorialize what that actually means. What seems to make the most sense to me is anchoring to the cycle of life which has been carried over for generations: we are born, we are children, we become educated young adults, we begin our careers, we leave the nest to form our own households, we have children of our own, we work to provide for our families, we work to save for our retirement, and we retire. Each of these steps represent a milestone in our lives, and to a great degree, the likeness of age we do each one of these things is contrasted with our parents. Thus, the demand for the goods and services at each of these milestones represent a demand which is more influenced by our aging than by price. That is to say, the prices of goods and services related to physical maturation is relatively inelastic.

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Figure 2: Year-over-year change in population aged 16-24, thousands

If much of demand grows by the schedule of maturing young adults, the same cannot so readily be said of supply. The role of demography in the corporate sector is largely contained within marketing departments, and far away from capital allocators who focus on much shorter-term objectives. Young adults find themselves with tougher prospects to break into the job market than any other age cohort [2]. Their inexperience makes them initially less desirable hires (a firm would generally prefer to hire one worker at twice the productivity than two at half the productivity), and the business sector eventually suffers (like it does now) from a deficit of experienced peak-aged workers.

This forms the basis of our demographic trap. Real goods and services are supplied by the production of real capital and labour. The configuration of output — the planning, training of people, purchase of machines — operates at a lag to the decisions of executives, and executives are hesitant to new capital expenditures before they see new demand.

These are frictions which resolve themselves over time. Unless policy, or another force hitherto unevident, prevents it, these frictions will also eventually resolve for Millennials. The main question is how quickly, and at what cost.

The Federal Reserve explicitly does not take responsibility for inflation from supply shocks. I will argue that its tolerance of 5.6% inflation in the 80’s indicates it implicitly distances itself from responsibility of demand shocks, too. Let us be candid and admit that there is a cost, both familial and more broadly societal to turn boys and girls into men and women. Even after they become young adults, taxpayers subsidize below market-rate student loans and colleges, businesses take on entry-level workers and apprentices, and the young adults form households largely by buying or renting at below replacement prices in areas with existing mature infrastructure and services.

The relevance this holds to the Federal Reserve is in the societal cost borne through the surplus inflation attributable to a bulging generation’s maturation. Based on the historical relationship between inflation and the size of the young age cohort, a 2% inflation target is unrealistic and incongruent with the Millennial generation, the biggest in history, forming households. It is difficult to imagine the economy running anywhere but far below its potential output if inflation is forcibly repressed under 2% while Millennials form households. Instead, an accommodative Federal Reserve will ultimately lower the average intensity and length of the elevated inflation by facilitating the creation of all the new real capital, housing stock and infrastructure required to serve the needs of the incoming generation. This real wealth will translate into greater future income, the ability to raise real interest rates, and less inflation because of the subsequent bending of the supply curve. In the same way you fight fire with fire, you can fight inflation with inflation – after all, as the saying goes, the cure for high prices is high prices. Since we have observed income gains to be sticky, the economic opportunity cost of suppressing this generation’s household formation could be optimistically measured in the trillions of dollars over our lifetimes. This is what makes you potentially the most important person in the world, most certainly in the country:  your decisions impact the standard of living of your son’s generation so greatly both contemporarily through (de-)incentivizing and facilitating (or suppressing) real capital formation into the capital factors of aggregate supply — homebuilding, infrastructure investment, factory machinery — as well as the resultant national income that real capital will generate even after you are gone.

Ms Yellen – thus I entreat you to explore raising the inflation target to a level which is more consistent with the demographic cards dealt to you. For Chairman Bernanke, perhaps 2% was an appropriate target. It was not for Chairmen Volcker or even for much of Greenspan’s tenure, and probably is not for you.

Congratulations & regards,

Matthew Busigin.

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2 Responses to Dear Ms Yellen: Raise the inflation target

  1. James C. says:

    Hello Matt,

    You conjecture, and then silently deny, “another force hitherto unevident”.

    I suggest that peak oil is such a force, and that American peak oil contributed to 1970s stagflation.

    I do not know how to navigate an industrial society through a restriction in energy supply, so I do not know how it affects the setting of the inflation target.

    In the book “The Death of Economics”, Paul Ormerod suggests that Germany coped a lot better with the 1970s than Britain, because the employers and employees could negotiate how the fall in real wealth would be shared out.

  2. Gabriel Syme says:

    Thanks much for your insight. What would you propose as an appropriate inflation target going forward? And what to make of the (potential) impact of robots/3D printing/smart machines/Skynet/the Singularity?

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