Recently, as US and UK inflation hit a 40-year high at 9.1 per cent and the inflation print in Germany came in at 8 per cent, it took me back to my interaction with Ben Bernanke, the former Chairman of the US Federal Reserve, in December 2012. During the course of this interaction, my substantive question to Bernanke was on the inflationary potential of central banks adopting a near-zero policy rate alongside QE (quantitative easing), which unleashed excess liquidity.

A number of leading economists, including Nobel laureate Edmund Phelps, held that post-crisis the US NAIRU (Non Accelerating Inflation Rate of Unemployment), which corresponds to full employment, had moved up to hover at 7.5 per cent levels. Therefore, exactly like the US Fed under Arthur Burns during the 1970s, the surmise was that the Fed under Bernanke may have been at near-zero interest rates with huge monetary stimulus in place, without realising that the economy was at full employment.

NAIRU is the lowest unemployment rate that can be sustained in an economy, without causing wage growth or inflation to rise. An actual unemployment rate lower than NAIRU is inflationary and wider this gap, higher the inflation.

Wrong call

The Fed, led by Arthur Burns, had thought that NAIRU was about 4 per cent and loosened policy only to land the US into massive double-digit inflation. This later forced Paul Volcker to raise interest rates as high as 20 per cent to quell inflation. This came at a huge cost to the US and other world economies. In fact, when bidding farewell from the Fed in 1979, Burns acknowledged that he had made a mistake in not realising that the NAIRU was 6 per cent plus rather than the 4 per cent he factored into his policies. Not directly answering my question and avoiding his own take on the prevailing NAIRU, Bernanke then said the Fed’s stance was a judgment call. In support of my question, there was other evidence to show that monetary transmission in the US was close to being dysfunctional.

At the time, banks had parked excess reserves of over $1.5 trillion with the Fed rather than on-lend to small businesses or households. Large businesses were sitting on a cash pile of $2 trillion and not investing in expansion. Asset bubbles were inflating similar to the pre-crisis period, with US TIPs (Treasury Inflation-Protected Security) trading at negative yields of 0.9 per cent.

However, months later, Bernanke took a cue from our interaction and made an unorthodox policy announcement that the Fed would continue with its QE, until the unemployment rate came down to 6.5 per cent. Of course, he did not explicitly term it as NAIRU and pegged the level one percentage point lower than what I had mentioned during my interaction — NAIRU of 7.5 per cent.

Lo and behold, in the US, the current NAIRU is 5 per cent and actual unemployment rate is lower at 3.6 per cent. Though I couldn’t get the current NAIRU statistics for the UK or Germany, the current 40-year high inflation rates mentioned above incontrovertibly suggest that, as in the US, one can surmise that in these economies too, NAIRU must be higher than actual unemployment rates and hence the high inflation.

Since NAIRU is a significant explanatory variable, though not the only one of accelerating inflation, the foregoing analysis should be reason enough for the RBI to start working with Government for building a credible and robust unemployment database and start using, inter alia, the NAIRU statistic in making monetary policy .

The writer is a former Executive Director, Reserve Bank of India

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