“The Phillips curve is the connective tissue between the Federal Reserve’s dual mandate goals of maximum employment and price stability.”
FRBNY President John C. Williams, USMPF Discussion, February 22, 2019.
“The White House wants highly capable, competent people who understand that you can have strong economic growth without higher inflation.” White House National Economic Council head Lawrence Kudlow, cited in The Wall Street Journal, January 24, 2019
U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years (see chart). One result is that temporary disturbances that drive inflation above or below target quickly fade.
Inflation and long-run inflation expectations, 1960- 3Q 2018
This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Indeed, if inflation were perfectly stable at 2%, we would observe zero correlation between unemployment and inflation! Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of peristently low unemployment on inflation.
Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). These recent authors do note the reduced impact of unemployment on inflation in recent decades, as well as the reduced impact of inflation shocks on the trend of inflation (see Figure 2.6). However, as they observe, these estimates do not exclude the possibility that prolonged periods of low unemployment could have a disproportionate impact on inflation.
The logic is straightforward: if labor is persistently very scarce, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices. Put differently, the authors of the 2019 USMPF report hypothesize that, when demand for labor exceeds supply markedly and for a long time, the result will be disproportionately larger wage and price inflation. So, if you focus on the 30 years starting in the mid-1980s, the Phillips curve appears relatively flat. In reality, however, it is just dormant. It is important that policymakers remain vigilant, as conditions could change rapidly with several years of very tight labor markets.
This concern leads the latest USMPF authors to examine state and local data for instances of persistent excess labor demand. For example, since 1980, more than 15% of annual state-level observations exhibit an unemployment rate less than 4% (see Figure 3.1 panel B). Interestingly, local data for metropolitan statistical areas (MSA) provide the most compelling statistical results. One might think that excess labor demand in even relatively large cities would attract inward migration, rather than lead employers to boost wages. However, as the next chart shows, the data confirm the authors’ hypothesis that the impact of unemployment on inflation is disproportionately larger when the unemployment rate is unusually low (see chart; see also Babb and Detmeister).
Differential Impact on Inflation of Unemployment According to MSA Unemployment Level, 1990-2017
Now, the evolution of the unemployment-inflation relationship is certainly subject to other interpretations. In his discussion of the USMPF paper, New York Fed President John Williams suggests that findings of differential impact (by unemployment level) in the relationship between unemployment and inflation are not robust. As an alternative, he argues that a combination of supply shocks, globalization and changes in market structure (think Amazon) mask the sustained impact of excess labor demand on inflation in aggregate data. Williams “rescues” the Phillips curve by appealing to an index that measures cyclically sensitive prices (see Stock and Watson): with this measure, the relationship between inflation and unemployment shows no sign of flattening and provides no evidence of disproportional impact at different levels of unemployment. At the same time, Williams confirms the widespread finding of diminished inflation persistence: the reduced impact of shocks on inflation’s trend.
The key point of both the 2019 USMPF paper and of Williams’ discussion is that there is little room for complacency. Low and stable inflation and inflation expectations reflect a credible policy commitment that requires policymakers to react forcefully when inflation deviates from target (and trend). Williams highlights the downside risks to inflation expectations arising from the extended period of below-target inflation. This argument seems particularly apt for Japan, where the central bank faces an entire generation that grew accustomed to deflation; and increasingly so for the euro area, where inflation has averaged only 1.2% over the past decade.
With U.S. inflation already averaging 1.9% over the past two years, and the economy well into the 10th year of the current business expansion, the authors of the USMPF paper worry more about the upside risks to inflation expectations. Echoing earlier comments from former Richmond Fed President Jeffrey Lacker, they note that the current U.S. episode has several features in common with the mid-1960s. Just prior to the Great Inflation there was: (1) an extended period of low and stable inflation and inflation expectations; (2) a tight labor market; (3) a large and pro-cyclical fiscal stimulus; and (4) a President pressuring the Federal Reserve to keep interest rates low.
The following scatter chart highlights just how exceptional the currently prevailing mix of low unemployment and high fiscal deficits is—even compared to the late 1960s. The red triangles show the Congressional Budget Office’s (CBO) projections for the three years from 2018 to 2020. The blue circles show the actual data for the four years from 1966 to 1969, when Vietnam War and Great Society expenditures boosted the federal deficit above cyclically adjusted norms.
Unemployment rate and the federal government deficit (Percent of GDP), 1960-2020
Unsurprisingly, we share the USMPF authors’ concerns about the threat President Trump’s attitudes and behavior poses to monetary policy that is successfully delivering price stability and maximum sustainable employment. We have written before about the damage to the Fed’s credibility from a President who, in response to FOMC rate hikes, reportedly wishes to fire the Fed Chair he appointed (see here). Perhaps the key concern today is the President’s authority to appoint like-minded supporters to the Federal Reserve Board, a point highlighted by the opening citation from his economic advisor, Lawrence Kudlow.
Ultimately, both the USMPF and President Williams have it right: to keep inflation close to 2%, the FOMC must remain committed to act (possibly aggressively) whenever inflation and inflation expectations threaten to deviate persistently from target. We have little doubt that the FOMC, as currently constituted, would do so. And, as FRB San Francisco President Mary Daly argued in her discussion of the USMPF paper, early indicators will likely provide the FOMC sufficient warning for a timely response. If anything, recent readings on survey and market measures of long-term inflation expectations reinforce the case for policy patience.
Indeed, whether the Phillips curve is alive, dead, or hibernating, there is little to suggest that the current Fed is complacent. We view the Fed’s public review of its monetary policy strategy, tools and communications precisely in this context: as Vice Chairman Richard Clarida highlights, the review—the first of its kind by the Fed—should position the central bank to reinforce its commitment to the 2% inflation target, helping to keep the inflation expectations anchor where it belongs.