Inflation Dynamics and the Great Recession

Abstract

This paper examines inflation dynamics in the United States since 1960, with a particular focus on the Great Recession. A puzzle emerges when Phillips curves estimated over 1960-2007 are used to predict inflation over 2008-10: inflation should have fallen by more than it did. We resolve this puzzle with two modifications of the Phillips curve, both suggested by theories of costly price adjustment: we measure core inflation with the weighted median of consumer price inflation rates across industries, and we allow the slope of the Phillips curve to change with the level and variance of inflation. We then examine the hypothesis of anchored inflation expectations. We find that expectations have been fully "shock-anchored" since the 1980s, while "level anchoring" has been gradual and partial, but significant. It is not clear whether expectations are sufficiently anchored to prevent deflation over the next few years. Finally, we show that the Great Recession provides fresh evidence against the New Keynesian Phillips curve with rational expectations. I n his presidential address before the American Economic Association, Milton Friedman (1968) presented a theory of the short-run behavior of inflation in which inflation depends on expected inflation and the gap between unemployment and its natural rate. Friedman also suggested that "unanticipated inflation. .. generally means. .. a rising rate of inflation," or in other words, that expected inflation is well proxied by past inflation. These assumptions imply an accelerationist Phillips curve that relates the change in inflation to the unemployment gap. In the decades since Friedman's work, his model has been a workhorse of macroeconomics. Researchers have refined the model extensively; two of the numerous examples are Robert Gordon's (1982, 1990) introduction

The dynamic relationship between core and headline inflation

“…See Le Bihan and Sédillot (2002), Bagliano and Morana (2003) and Stardev (2010) for discussions of forecasting in Europe. 4 Differences in the dynamic relationship between core and headline inflation across a 1979 or early 1980s sample split have been identified by other authors as well: Blinder and Reis (2005), Ball andMazumder (2011), Clark (2001), Mishkin (2007), Rosengren (2011), Rich and Steindel (2005), and Smith (2005). 5 See also Benati (2008), Dossche and Everaert (2005), Hondroyiannis and Lazaretou (2004), Lansing (2009), Levin and Piger (2002), Leduc, Keith, andTom, 2007.…”

Identifying the Phillips curve through shifts in volatility

“…Another issue is that the Phillips curve slope might change over time. Recently, Ball and Mazumder (2011) have shown for the US that the slope of the Phillips curve might be varying over different time periods. In order to check whether the coefficient on the output gap in the Phillips curve is constant over time, we split the sample in two parts and apply the same identification method for a relevant subsample.…”

“…The method of identification through heteroskedasticity requires that the contemporaneous coefficients are time-invariant over the subsamples (see Section 2). We split the sample in 1985Q1 as in Ball and Mazumder (2011), which marks the end of the disinflation period and the start of the Great Moderation. In addition we use the trend variables of the unemployment rate and inflation rate as estimated over the whole sample in order to focus on changes of the Phillips curve slopes for given estimates for the NAIRU and trend inflation.…”

Finding a Stable Phillips Curve Relationship: A Persistence-Dependent Regression Model

“…But by most accounts, inflation dynamics over the Great Recession seem to have diverged markedly from their previous patterns, posing a number of puzzles to the existing understanding of the Phillips curve relationship. The most prominent puzzle is the missing disinflation: given the large amount of labor market slack that persisted for many years, standard pre-Great-Recession Phillips curve specifications predicted far lower inflation over the Great Recession than actually occurred (see, for example, Ball and Mazumder 2011;Coibion and Gorodnichenko 2015). It seems almost universally believed that the Phillips curve relationship has weakened.…”