The Outlook for US Inflation and Monetary Policy

Joseph E. GagnonApril 2, 2019

Peterson Institute for International Economics | 1750 Massachusetts Ave., NW | Washington, DC 200364/2/2019 1

Is Inflation AWOL?• Unemployment is projected to be below its natural rate in

2019 and 2020.

Note: FOMC data are median values from the Summary of Economic Projections from the March 2019 FOMC meeting. Blue Chip data are the consensus (average) values from the March 2019 survey.

Unemployment rate (percent)Actual, February 2019 3.8Projected, Blue Chip, 2020 3.7

Natural rate of unemployment (percent)Congressional Budget Office (CBO) (long-run) 4.6Federal Open Market Committee (FOMC) (“longer-run”) 4.3Blue Chip Economic Indicators (2025 projection) 4.3

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Is Inflation AWOL?

• Yet inflation is projected to be low and stable.

Note: FOMC data are median values from the Summary of Economic Projections from the March 2019 FOMC meeting. Blue Chip data are the consensus (average) values from the March 2019 survey.

Q4/Q4, percent FOMC core PCE Inflation Blue Chip CPI Inflation2018 1.9 2.22019 2.0 2.02020 2.0 2.22021 2.0 2.2

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The Phillips Curve

-4

-3

-2

-1

0

1

2

3

4

-6 -4 -2 0 2 4 6Chan

ge in

infla

tion,

per

cent

age

poin

ts

Unemployment gap, percent

1967-94, high inflation

Source: Authors’ illustration.

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The Phillips Curve

-4

-3

-2

-1

0

1

2

3

4

-6 -4 -2 0 2 4 6Chan

ge in

infla

tion,

per

cent

age

poin

ts

Unemployment gap, percent

1995-2018, low inflation

Source: Authors’ illustration.

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The Phillips Curve

-4

-3

-2

-1

0

1

2

3

4

-6 -4 -2 0 2 4 6Chan

ge in

infla

tion,

per

cent

age

poin

ts

Unemployment gap, percent

1995-2018, low inflation

Source: Authors’ illustration.

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Downward Wage and Price Rigidity

• Even in good times, some firms have weak sales.– These firms raise price less than average.– Other firms raise price more than average.

• To allow average inflation to approach 0, some firms must cut wages and prices.

• Many firms resist cutting wages and prices.– They may accept lost sales and layoffs instead.

• Downward wage and price rigidity bends the Phillips curve when inflation is low.

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Low Inflation Bends the Phillips Curve

Source: Gagnon and Collins (2019, figure 2).8

0

5

10

15

-10 -5 0 5 10 15

Infla

tion,

per

cent

Unemployment gap, percent

∆Pe=0 ∆Pe=1 ∆Pe=3 ∆Pe=5 ∆Pe=10

Source: Gagnon and Collins (2019, figure 6).

Two Versions of the Phillips Curve(based on core CPI inflation)

Unemployment gap, percent

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-4

-3

-2

-1

0

1

2

3

4

-5 -4 -3 -2 -1 0 1 2 3 4 5

High Inflation

-4

-3

-2

-1

0

1

2

3

4

-5 -4 -3 -2 -1 0 1 2 3 4 5

Low Inflation

Chan

ge in

infla

tion,

per

cent

age

poin

ts

∆𝑃𝑃𝑡𝑡= 𝛾𝛾𝐺𝐺𝐺𝐺𝑃𝑃𝑡𝑡 + 𝛼𝛼 + 𝛽𝛽∆𝑃𝑃𝑡𝑡−1

• Accelerationist model β=1: Inflation builds on itself• Phillips curve describes change in inflation

• Anchored model β=0: Inflation returns to a fixed anchor• Phillips curve describes level of inflation

• Inflation moved from anchored before 1967 to accelerationist in 1967-94 to anchored in 1995-2018.

The Rest of the Model

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Is Inflation Anchored Too Low?

11

-1

0

1

2

3

4

1995q1 2000q1 2005q1 2010q1 2015q1

Core PCE Headline PCE

4-qu

arte

r cha

nges

, per

cent

Projections with Anchored Inflation Models

Source: Gagnon and Collins (2019, figure 8).

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Perc

ent

2

2.5

3

3.5

4

ECI (4-quarter change)

1

1.5

2

2.5

3

Core CPI (4-quarter change)

Projections with Accelerationist Inflation Models

Source: Gagnon and Collins (2019, figure 9).

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Perc

ent

1

2

3

4

5

ECI (4-quarter change)

1

2

3

4

5

Core CPI (4-quarter change)

US Monetary Policy Dilemma

• Fed chair Jerome Powell expressed doubt last month that inflation expectations are anchored at 2 percent.

• The abrupt pause in expected rate hikes may reflect concern about the risk of another undershoot.

• Some overshooting of 2 percent target may be useful in raising the inflation anchor to 2 percent.

• The Fed is likely to hit the zero bound on its short-term interest rate tool in the next recession.– QE can help, but possibly not as much as Fed would like.– Inflation may undershoot and unemployment may be too high.

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The Fed’s Ongoing Review of Its Policy Strategy

• Monetary policy can achieve its goals better by intentionally overshooting the inflation target after an undershoot at the zero bound.– Bernanke, Kiley, and Roberts (2019)

• If the Fed moves in this direction, it may not resist some modest overshooting of its inflation target next year.

• Better to switch to the new policy strategy before the next recession hits.– A new promise to raise future inflation during a recession may

not be fully credible.

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Is Inflation AWOL?

• FOMC and private forecasts may underpredict inflation.• A modest overshoot of the Fed’s target by 2020 is likely.• This may be an “error” that is welcomed by the Fed.

Note: FOMC data are median values from the Summary of Economic Projections from the March 2019 FOMC meeting. Blue Chip data are the consensus (average) values from the March 2019 survey.

Q4/Q4, percent FOMC core PCE Inflation Blue Chip CPI Inflation

2018 1.9 2.2

2019 2.0 2.0

2020 2.0 2.2

2021 2.0 2.2

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References

Bernanke, Ben, Michael Kiley, and John Roberts. 2019. Monetary Policy Strategies for a Low-Rate Environment. Finance and Economics Discussion Series No. 2019-009. Washington: Board of Governors of the Federal Reserve System.

Gagnon, Joseph, and Christopher Collins. 2019. Low Inflation Bends the Phillips Curve. PIIE Working Paper No. 19-6. Washington: Peterson Institute for International Economics.

Phillips, Alban. 1958. The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. Economica 25: 283-99.

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