There has been a lot of discussion in the press and elsewhere about the meaning of the natural rate hypothesis in a low inflation environment, whether it applies as typically and perhaps some other factors are masking the effect, or is there some doubt about whether it is true in a predictable and absolute sense.

For disclosure purposes, my leanings are somewhere in between the two points. In an extremely simplified example of the natural rate, in a closed economy, there are only so many people available for work to produce the goods everyone wants to buy. As the economy expands, the amount of people available for work declines, and the idea here is that labor will become scarce, employers will necessarily bid up wages, and then need to raise prices to reflect the additional cost of doing business without added quality in the products or productivity gains. And in that example, there will be a certain level of employment that would drive gains in inflation measures that is likely somewhat predictable. Though at what level of employment it applies varies with the any given mix of supply side polices and exogenous shocks.

But like many theories in economics, they apply fully in certain situations while having limited impact in others, if any at all, depending on the type of monetary policy regime in place, trade policy, and the uncontrollable things that happen globally. In my opinion, for whatever it is worth, the natural rate hypotheses likely holds true in the basic sense there are indeed only so many people available for work to produce goods other want to buy. But in a more liberalized economy that engages in trade agreements that allow for the importation of labor, like NAFTA, employers in that economy can choose from a wider scope of candidates than what is available domestically. In the case of NAFTA, employers in the US have a whole continent of potential workers to choose from, and domestic labor scarcity that is claimed to be signified by the 4.1% headline unemployment rate and has a looming high impact on inflation measures in the near future is probably a gross overstatement, and for more reasons than labor availability.

NAFTA and other trade agreements also impact the supply and availability of goods that are in demand by producing the goods people want with production capacity that is available elsewhere, often at lower cost. So even if domestic labor scarcity were a problem, the impact on inflation would not be the same as in a closed economy where these goods would not be available in the quantity demanded. In short, liberalized trade agreements likely reduce the natural rate of inflation accelerating unemployment compared to a closed economy by some degree, though I doubt anyone really knows by how much. It’s hard enough to get people to accept that ideas that used to be true and reliable under yesterday’s circumstances may no longer be true under the circumstances of the today, let alone get them sit down and figure out the meaning of it all.

I am not aware of trade agreements that apply to Japan, but there have been extraordinary efforts on the part of monetary policymakers to comply with a 2% inflation target over the last five years that have resulted in inflation measures hovering around 1% with the headline unemployment rate being pushed down to just above 2%, and I would guess that trade policy may have something to do with this puzzle of why that low of an unemployment rate hasn’t had the impact on inflation measures many expected.