Less Need to Worry About Inflation

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Last week, Dean Baker and I asserted on this blog that the Phillips Curve has flattened over the years, and this development means policy makers face a diminished risk of inflation in the pursuit of full employment.

This week, I’d like to unpack that very dense sentence.

First, what’s the Phillips Curve (and who was Phillips)? For one, he was a Kiwi, one of a line now including the great New Zealand economists Julia Lane and Chye-Ching Huang (to name only the ones I personally know). The Phillips Curve is a negatively sloping line in a graph with wage or price growth on the Y axis and unemployment on the X axis. The more slack in the job market, the less pressure we expect on wage growth and thus price growth.

Now, when you think unemployment/inflation trade-off, you are likely to think of the Federal Reserve. When its governors ply monetary policy to lower unemployment, as they’re doing today, they typically worry about pushing too far and generating inflation. The Phillips Curve tells them how much to worry, i.e., how much they would expect inflation to accelerate for each percentage point reduction in unemployment.

We’ll get to the main event - the flattening of the curve - in a moment, but first we need to dive a bit deeper into the Phillips Curve weeds. The equation below is one way economists think of the curve these days, and it will help in our analysis of how it has changed over time.

inf = inf_exp - K x (U-U*)

Inflation (inf in the equation) today is a function of expected inflation minus the slope of the curve (that’s the “K,” for Kiwi) times the unemployment gap, a measure of labor market slack defined by the actual unemployment rate minus the full employment rate. Each one of those terms to the right of the equal sign has evolved in important ways.

First, it is widely believed that inflationary expectations have become increasingly well-anchored. The Fed has convinced people that inflation will generally flit about its target rate of 2 percent. That doesn’t mean the Fed can stop a price spike resulting from some supply shock or other, like a disruption to the oil supply. But the expectation is embedded in the system such that once the temporary shock is resolved, inflation will settle back to its expected rate.

Second, K, the negative slope of the Phillips Curve, has drifted up toward zero. My own estimate is shown below in the solid line, using the same method as in this important paper by Laurence Ball and Sandeep Mazumder.

Author’s estimation of Equation (3) in “Inflation Dynamics and the Great Recession,” by Laurence Ball and Sandeep Mazumder (link above), as in their Figure 3b.  Author used the personal consumption expenditures core inflation measure as opposed to the consumer price index core used in their paper. The dotted lines represent two standard errors.

Clearly, K has moved around over time, posting the biggest negatives in the 1970s, when inflation was buffeted about by supply shocks and poorly anchored. In fact, the 1970s is the only period wherein the standard error lines do not cross zero, suggesting the slope has actually been hard to identify with precision for most of its recent life.

Most recently, K by this estimate has been around zero. If that were true, and I don’t think it is, there would be no trade-off at all. But as Dean Baker and I wrote last week, “The fact that inflation has grown less responsive to lower unemployment means the weighting of the risks associated with the unemployment-inflation trade-off has changed in favor of full employment.”

True, one could assert that a flatter curve actually makes it harder for the Fed to reduce price pressures through higher unemployment, but I don’t think that’s a problem. In fact, along with the stronger anchoring function, numerous other factors are probably reducing inflation these days, including the increased supply of goods courtesy of globalization and sticky nominal wages. The Phillips Curve is a stalwart macroeconomic war horse, but it’s an awfully simple, if not reductionist, construct.

One last point. There’s something important and interesting going on with the last part of that equation above. First, U (the unemployment rate) is biased down because so many people have dropped out of the labor force, meaning the actual unemployment gap is larger than the measured one and implying that the labor market is probably putting more downward pressure on prices than we thought (and suggesting that the Fed should lower its unemployment target accordingly).

Second, and this pushes the other way (i.e., toward a smaller unemployment gap), the share of the unemployed who are long-termers is higher than it has ever been, and this too plays out in the Phillips Curve. A fundamental relation behind the curve is that as more unemployed unsuccessfully search for work, wage and price pressures diminish. But other research finds that the longer you’re unemployed, the less intense is your job search, so these folks may have little impact on wage pressure.

The interesting point about this right now is that if you ran an equation like the one above on today’s data, you might expect deflation. One reason we’re not there may be because all those long-termers raise the unemployment rate but don’t put much downward pressure on wages and prices.

The key conclusion is that the trade-off between unemployment and inflation is a lot less steep than it used to be, inflationary expectations are well-anchored and, even in good times, most workers these days have little bargaining power. That’s one reason they’re seeing so few gains from a recovery that’s a lot more evident on Wall Street than on Main Street.

So policy makers should seriously down-weight the phantom menace of inflation. Even if they overshoot on the unemployment side, an extremely unlikely result in today’s policy climate, the impact on prices is likely to be minimal.