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Stop Inflating the Inflation Threat: Project Syndicate


Project Syndicate: Stop Inflating the Inflation Threat Given the scale and severity of inflation in America in the 1970s, it is understandable that US monetary policymakers developed a deep-seated fear of it. But, nearly a half-century later, the conditions that justified such worries no longer apply, and it is past time that we stopped denying what the data are telling us.: I remember September 2014: That month the U.S. unemployment rate dropped below 6%, and I was assured by very many that that meant that the Phillips Curve predicted that inflation would soon be on the rise, and that it was time for the Federal Reserve to begin to—rapidly—normalize monetary policy—to begin shrinking the monetary base, and raising interest rates back into a "normal" range. Today unemployment is 2.5%-points lower than what I was then assured was the "natural" rate of unemployment. According to the rule-of-thumb as they stood back when I was an assistant professor in 1990, such a low unemployment rate should lead annual inflation to climb by 1.3%-points every year: if this year inflation were to be 2.0%, next year's would be 3.3%, and—if unemployment stayed this low—the year after that's would be 4.6%, and the year after that 5.9%.

But that is not going to happen. Inflation will stay about 2% for the next several years. The old rule-of-thumb no longer applies. And that should drive our monetary policy choices.

Now the conventional wisdom among economists as it stood back in 1990 was correct, for then. The fact is that in the United States between 1957 and 1988—the first half of the last 60 years—the slope of the simplest-possible adaptive-expectations Phillips Curve was -0.54: each one-percentage point fall in unemployment below the estimated natural rate boosted inflation in the subsequent year by 0.54%-points above its contemporary value.

But that was then. This is now. Since 1988—for the second half of the past 60 years—the slope of this simplest-possible Phillips curve has been effectively zero: the estimated regression coefficient has been not -0.54 but only -0.03. Even as unemployment has gotten far below what economists presumed was the natural rate of unemployment recently, inflation in the United States has not accelerated. And even when unemployment got far above what economists presumed was the natural rate of unemployment over 2009-2014, inflation did not fall and deflation did not set in. The estimated regression-analysis coefficient of -0.03 is telling us that as unemployment has fluctuated since the late 1980s, inflation has not.

By contrast, in the U.S. from the late 1950s to the late 1980s, when unemployment fluctuated inflation responded. The most important observations driving the estimated negative slope of the Phillips Curve in the first half of the past sixty years were six: In 1966, 1973, and 1974, inflation jumped up in times of relatively-low unemployment. In 1975, 1981, and 1982, inflation fell in times of relatively-high unemployment. But we have no analogues to those years in the past generation.

Nevertheless, there are many people who believe that an acceleration of inflation is a significant risk that monetary policymakers need to focus on—that the more important danger is of an outbreak of higher inflation rather than the possibility of recession. The very sharp Peter Hooper, Frederic S. Mishkin, and Amir Sufi, for example, argue that the American Phillips Curve is "just hibernating", and that the estimates that show the past generation's Phillips Curve as essentially flat are untrustworthy because of "endogeneity of monetary policy and the lack of variation of the unemployment gap". But this I do not understand: the computer tells us that the 1988-2018 estimates are three times as precise as the 1957-1987 ones, and standard specifications of the Phillips Curve slope look at too short a window for any monetary policy reaction to be substantial.

Yes, an outbreak of inflation could be a threat. Yes, if we had analogues of (a) two presidents, Johnson and Nixon, desperate for a persistent high-pressure economy; (b) a Federal Reserve chair like Arthur Burns eager to accommodate presidential demands; (c) the rise of a global monopoly in the economy's key input able to deliver mammoth supply shocks; and (d) a decade of bad luck; then we might see a return to inflation as it was in the (pre-Iran crisis) early and mid-1970s. But is that really the tail risk we should be focused on?

It is long past time to take seriously what the data are telling us: until the structure of the economy and economic policy changes again, there is little risk that over the next five years we will find ourselves facing a painful excessive-inflation problem. Monetary policymakers should be focused on other problems, and other risks.

And how is it, exactly, that "the difference between national and city/state results in recent decades can be explained by the success that monetary policy has had in quelling inflation and anchoring inflation expectations since the 1980s"? Neither of those two should affect the estimated coefficient. Much more likely is simply that—at the national level and at the city/state level—the Phillips Curve becomes flat when inflation becomes low.

the evidence for "significant nonlinearity" in the Phillips Curve is that the curve flattens when inflation is low, not that it steepens when labor slack is low. There is simply no "strong evidence" of significant steepening with low labor slack. Yes, you can find specifications with a t-statistic of 2 in which this is the case, but you have to work hard to find such specifications, and your results are fragile.

The most important observations driving the estimated zero slope of the Phillips Curve in the second half of the past sixty years have been 2009-2014: the failure of inflation to fall as the economy took its Great-Recession excursion to a high-unemployment labor market with enormous slack.

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