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Monday, February 26, 2007

The Weakened Link Between Unemployment and Inflation

Greg Ip reports that the relationship between inflation and unemployment seems to have shifted over time. Variations in output and unemployment in the current time period appear to have less influence over future inflation than they did twenty five years ago:

Policy Makers At Fed Rethink Inflation's Roots, by Greg Ip, Wall Street Journal: For decades, a simple rule has governed how the Federal Reserve views the nation's economy: When unemployment falls too low, inflation goes up, and vice versa.

But Fed officials have rethought that notion. They believe it takes a far bigger change in unemployment to affect inflation today than it did 25 years ago. Now, when inflation fluctuates, they are far more likely to blame temporary factors, such as changes in oil prices or rents...

One explanation for why inflation is influenced less by changes in unemployment is that the American public has come to expect inflation to remain stable. When inflation moves up or down, it is less likely to get stuck at the new level because companies and workers don't factor the change into their expectations... Another explanation is that the Fed is better at adjusting interest rates in anticipation of swings in unemployment before those swings can affect inflation.

This ... doesn't mean unemployment can be ignored. But it does mean that in the short run, a period of high or low joblessness would be less likely to alter the Fed's view of inflation and trigger an immediate change in interest rates. A shift in public expectations of inflation, however, would carry more weight in the Fed's calculations. ...

Though the trend has been under way for 25 years, only recently has intensive research by Fed economists and others incorporated it into mainstream thinking. ...

"Among the feet-on-the-ground Fed inflation forecasters, who do this for a living, there's been a lot of concern for the last 10 years about whether there's...less of a relationship between output and future inflation," says Harvard University economist James Stock. "The accumulation of evidence occurs at a snail's pace. The evidence now is a lot stronger."

Mr. Stock and fellow economist Mark Watson at Princeton University presented evidence ... in late 2005 that inflation's long-term trend has varied little since 1984, and that most fluctuations were the result of temporary disturbances, such as a change in energy prices. ...

While a given drop in unemployment is less likely to spark inflation, the potential is still there. The Fed's staff estimates it takes up to twice as much additional unemployment to achieve a percentage drop in inflation as it did before 1984. ...

What Stock and Watson have shown (e.g. see  “Has Inflation Become Harder to Forecast?") is that inflation is both harder and easier to forecast at the same time. It's easier because it is more stable. Thus, the root mean square error for even fairly naive forecasts has fallen over time as inflation has stabilized. However, inflation has become harder to forecast because changes in real activity such as unemployment or output have less predictive power for future inflation than in the past.

What is the source of the change in the relationship? At the end of the paper Stock and Watson say:

One thing this paper has not done is to attempt to link these changes in time series properties to more fundamental changes in the economy. The obvious explanation is that these changes stem from changes in the conduct of monetary policy in the post-1984 era, moving from a reactive to a forward-looking stance... But obvious explanations are not always the right ones, and there are other possibilities. To a considerable extent, these other possibilities are similar to the ones raised in the context of the discussion of the great moderation, including changes in the structure of the real economy, the deepening of financial markets, and possible changes in the nature of the structural shocks hitting the economy. We do not attempt to sort through these explanations here, but simply raise them to point out that the question of deeper causes for these changes merits further discussion.

I think it's a combination of technological change (in particular, computers and digital technology that improved business processes, e.g. inventory management) and better monetary policy. Monetary policy has improved by reducing unexpected policy changes through transparency and enhanced credibility, and the implementation of inflation targeting rules that have stabilized both expected and actual inflation.

    Posted by on Monday, February 26, 2007 at 12:06 AM in Economics, Inflation, Unemployment | Permalink  TrackBack (0)  Comments (16)



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