Monetary policy: How does inflation matter?: THE IMF's recently published a thought-provoking analysis on changes in the apparent relationship between inflation and unemployment…. I've since reflected more on the work, and on some related writing by Nick Rowe…. The IMF notes the stability of inflation expectations and reckons that it is attributable to central bank credibility…. Inflation expectations became so well anchored that not even the worst few months of economic performance since the 1930s could produce deflation. I've been thinking about whether that narrative seems right….
The encouraging takeaway from this story, if it is true, is that the Fed can and should do much more to support the economy. Thanks to its laudable achievement in sticking inflation expectations to the sticking place there is very little risk that aggressive monetary stimulus will lead to soaring inflation. And so the Fed should ease away….
[But] let's try another story. In September of 2008, the American economy was hit with a massive demand shock…. Amid falling demand, every flexible price in the economy began to drop like a stone…. But many, many prices did not fall…. Was substantial wage rigidity a new phenomenon? It is possible that the Great Moderation era of low and stable inflation broke firms and households of the habit of adjusting prices and wage demands frequently…. Note that in that case, it is the "stable" part of low and stable inflation that is causing trouble…. [M]aybe the Fed's efforts to reduce the overall level of inflation moved the economy into the flattest portion of the Phillips Curve, where historically regular wage rigidities turned a given drop in output into a much smaller decline in inflation. Then, an inflation-focused central bank accustomed to a very different looking Phillips Curve dramatically underestimated the severity of the downturn….
[W]e're stuck trying to square a large chunk of cyclical unemployment with well-behaved inflation….
[I]f the Fed believes that its credibility is the reason inflation has been stable during the recovery, then it will almost certainly continue to do too little and unemployment will eventually settle a natural rate substantially higher than the pre-crisis level. If, on the other hand, it determines that wage rigidities are mostly responsible for stable inflation, then the Fed must actively seek a higher inflation rate in order to increase employment growth.
I don't think it's learning that lesson quickly enough.