NBER WORKING PAPER SERIES THE PHILLIPS CURVE IS ALIVE AND WELL: INFLATION AND THE NAIRU DURING THE SLOW RECOVERY Robert J. Gordon Working Paper 19390 http://www.nber.org/papers/w19390 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2013 I am grateful to Ranjodh (R. J.) Singh for excellent research assistance, and to generations of previous research assistants who have maintained the continuity of the triangle model since 1982. Ian Dew-Becker is responsible for devising the treatment of changing productivity trends in our joint (2005) paper. A suggestion by James Stock in mid-July, 2013, rekindled my interest in updating the triangle model and led to the further exploration of the distinction between total and short-run unemployment (see Stock, 2011 and Astrayuda-Ball-Mazumdar, 2013). The exposition and critique of the New-Keynesian Phillips Curve here is updated from Gordon (2007). A broader survey of the first five decades of the Phillips Curve is contained in Gordon (2011) and includes a deeper and more complete analysis of the contrast between the NKPC and triangle approaches. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2013 by Robert J. Gordon. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. The Phillips Curve is Alive and Well: Inflation and the NAIRU During the Slow Recovery Robert J. Gordon NBER Working Paper No. 19390 August 2013 JEL No. E00,E31,E52,J60,J64 ABSTRACT The Phillips Curve (hereafter PC) is widely viewed as dead, destined to the mortuary scrapyard of discarded economic ideas. The coroner’s evidence consists of the small standard deviation of the core inflation rate in the past two decades despite substantial volatility of the unemployment rate, and in particular the common tendency of PC inflation equations to predict ever greater amounts of negative inflation (i.e., deflation) over the years of labor-market slack since 2008, sometimes called “the case of the missing deflation”. The apparent failure of the PC deprives the Fed of a means of estimating the natural rate of unemployment (or NAIRU), and thus the Fed is steering the economy in a fog with no navigational device to determine the size of the unemployment gap, one of the two primary goals of its “dual mandate.” The results of this paper contain important new information for Fed policymakers, for Fed-watchers, and almost everyone else in the community of policy-makers and practitioners of applied macro. The greatest failure in the history of the PC occurred not within the past five years but rather in the mid-1970s, when the predicted negative relation between inflation and unemployment turned out to be utterly wrong. Instead inflation exhibited a strong positive correlation with unemployment. Failure bred success, as a revolution in thinking rebuilt macroeconomics to be not just about demand, but also about supply. By 1980 diagrams of shifting demand and supply curves had appeared in most macroeconomics textbooks. An econometric model of the inflation rate developed in 1982, soon dubbed the “triangle model”, incorporated explicit variables for supply shifts and has successfully tracked inflation behavior since then. The triangle model shows that the puzzle of missing deflation is in fact no puzzle. It can estimate coefficients up to 1996 and then in a 16-year-long dynamic simulation, with no information on the actual values of lagged inflation, predict the 2013:Q1 value of inflation to within 0.50 of a percentage point. The slope of the PC relationship between inflation and unemployment does not decline by half or more, as in the recent literature, but instead is stable. The model’s simulation success is furthered here by recognizing the greater impact on inflation of short-run unemployment (spells of 26 weeks or less) than of long-run unemployment. The implied NAIRU for the total unemployment rate has risen since 2007 from 4.8 to 6.5 percent, raising new challenges for the Fed’s ability to carry out its dual mandate. Robert J. Gordon Department of Economics Northwestern University Evanston, IL 60208-2600 and NBER [email protected] TABLE OF CONTENTS 1. Introduction .............................................................................................................................1 1.1 The Case of the Missing Deflation ...............................................................................1 1.2 The Triangle Model Provides a Solution ....................................................................3 1.3 Has the Phillips Curve Flattened? ................................................................................5 1.4 Plan of the Paper ..............................................................................................................6 2. The New-Keynesian and Triangle Specifications of the Phillips Curve .....................6 2.1 The New-Keynesian Phillips Curve (NKPC) Model ................................................6 2.2 The “Triangle” Model and the Role of Demand and Supply Shocks ...................9 3. The Explanation of Inflation in the NKPC and Triangle Models ...............................13 3.1 Plots of the Basic Data ...................................................................................................13 3.2 Coefficients and Dynamic Simulations of the Two Models .................................15 3.3 The Distinction Between Short-run and Long-run Unemployment ....................22 4. Implied NAIRUs and Policy Implications .......................................................................28 4.1 The Implied Time-Varying NAIRUs and the Question of Whether Structural Unemployment Has Increased ................................................................................................28 4.2 Simulations of Inflation to 2023 Along Alternative Recovery Paths ...................30 5. Core Inflation and Coefficient Stability ...........................................................................32 5.1 Triangle Results for Core Inflation ............................................................................32 5.2 Specification Bias and Changes of Coefficients in Rolling Regressions ............35 6. Conclusions and Policy Implications................................................................................37 Appendix A. NKPC Results with a Time-Varying NAIRU ..............................................42 Appendix B. The NKPC Model is Nested in the Triangle Model: Significance Tests of Omitted Lags and Omitted Variables ....................................................................................48 References ....................................................................................................................................51 The Phillips Curve is Alive and Well, Page 1 1. Introduction It is widely believed that the Phillips Curve is dead. The U. S. economy during the past five years has experienced stable inflation in the face of prolonged slack in the labor market. According to the standard expectational Phillips Curve (hereafter PC), inflation depends on the expected rate of inflation and the gap between actual and equilibrium unemployment, otherwise known as the natural rate of unemployment or the NAIRU (“Non-Accelerating Inflation Rate of Unemployment”). In this version of the PC with backward-looking (adaptive) expectations, a prolonged period of a positive unemployment gap, as has existed over the five years since mid-2008, mechanically predicts that the inflation rate in each quarter will be lower than in the previous quarter. Several research papers have shown that this model predicts that the inflation rate by now should have declined well into deflationary territory, with an annualized negative inflation rate of as much as minus 4 percent. 1.1 The Case of the Missing Deflation With no barrier to prevent the inflation rate from turning from positive to negative, the standard Phillips curve has predicted an accelerating deflation after 2008. Because the actual inflation rate has not turned negative but rather has been relatively stable in the range of one to two percent, except when temporarily perturbed by movements in oil prices, the standard Phillips Curve has been discredited. As a result efforts to estimate the time-varying NAIRU (TV-NAIRU) seem to have ceased. The Federal Reserve hence lacks the basic information it needs to carry out its dual mandate, because it cannot estimate the size of the output or unemployment gaps without a viable PC specification needed to estimate the TV-NAIRU. Any attempt to apply the Taylor Rule to monetary policy is missing one of its key ingredients: the size of the output or unemployment gap. The “missing deflation puzzle” was summarized three years ago by John Williams, now President of the San Francisco Fed, when he said: The surprise [about inflation] is that it’s fallen so little, given the depth and duration of the recent downturn. Based on the experience of past severe recessions, I would have expected inflation to fall by twice as much as it has (Williams 2010, p. 8). Numerous papers have attempted to solve