Policy Brief NUMBER PB16-1 JANUARY 2016 Each of the last three conclusions presents challenges for The US Phillips Curve: the conduct of monetary policy. Wisdom gained from the expe- Back to the 60s? rience of the 1960s and later will be needed. A BRIEF LITERATURE REVIEW Olivier Blanchard Th is Policy Brief extends Blanchard, Cerutti, and Summers Olivier Blanchard joined the Peterson Institute for International (2015), where we examined the evolution of the relation between Economics as the fi rst C. Fred Bergsten Senior Fellow in October 2015. In infl ation and unemployment for 20 advanced economies. Th at 2008, he took a leave of absence to be the economic counselor and director paper builds in turn on chapter 3 in the IMF World Economic of the Research Department of the International Monetary Fund. He remains Robert M. Solow Professor of Economics emeritus at MIT. Outlook (2013) on the same topic. Our conclusions mostly coin- cide with the empirical conclusions of the two closest papers we © Peterson Institute for International Economics. All rights reserved. know of on this topic, Ball and Mazumder (2011) and Kiley (2015) (which includes a review of other papers). Th e behavior of infl ation since the global fi nancial crisis appears puzzling to many. To cite Paul Krugman (2015): “If infl ation AN ECONOMETRIC EXERCISE had responded to the Great Recession and aftermath the way it did in previous slumps, we would be deep in defl ation by now: Since the estimation of the US Phillips curve by Paul Samuelson we aren’t.” and Robert Solow, macroeconomists have learned, often pain- With this in mind, this Policy Brief ree xamines the behavior fully, that while low unemployment creates infl ation pressure, of infl ation and unemployment. It reaches four conclusions: the form of the relation can change and has changed over time. Low unemployment still pushes infl ation up; high unem- To examine its evolution, we estimated the following specifi ca- ployment pushes it down. Put another way, the US Phillips tion in Blanchard, Cerutti, and Summers (2015): curve is alive. (I wish I could say “alive and well,” but it * e would be an overstatement: Th e relation has never been STtttt ()uu OS tt (1)* OS tt1 PSH tmtt (1) very tight.) e SDESKttttt * 1 (2) Infl ation expectations, however, have become steadily more anchored, leading to a relation between the unemployment where t is headline consumer price infl ation (defi ned as quar- * rate and the level of infl ation rather than the change in infl a- terly infl ation, annualized), ut is the unemployment rate, ut is e tion. In this sense, the relation resembles more the Phillips the natural rate, t is long-term infl ation expectations, *t–1 is curve of the 1960s than the accelerationist Phillips curve of the average of the last four quarterly infl ation rates, mt is import the later period. price infl ation relative to headline infl ation, and the parameters , , , , , and the natural rate u * follow constrained Th e slope of the Phillips curve, i.e., the eff ect of the unem- t t t t t t random walks. ployment rate on infl ation given expected infl ation, has Th e fi rst equation specifi es the Phillips curve. Infl ation substantially declined. But the decline dates back to the depends on both expected long-term infl ation and past infl a- 1980s rather than to the crisis. Th ere is no evidence of a tion. Th e coeffi cient on past infl ation refl ects the dependence of further decline during the crisis. short-term infl ation expectations on past infl ation as well as the Th e standard error of the residual in the relation is large, direct eff ects of past infl ation on current infl ation. Infl ation also especially in comparison to the low level of infl ation. depends on the deviation of the unemployment rate from the 1750 Massachusetts Avenue, NW Washington, DC 20036 Tel: (202) 328-9000 Fax: (202) 328-5432 www.piie.com NUMBER PB16-1 JANUARY 2016 natural rate, as well as on the relative price of imports. Th e second Th e main results are presented in the three fi gures below. equation (which was not estimated in the Blanchard, Cerutti, and (For lack of space, results on the evolution of the natural rate Summers paper) captures the dependence of long-term expected are not presented here. Th e data suggest a slow decline in the infl ation on lagged infl ation. To capture the evolution of the two natural rate by about 1 percentage point since the early 1980s.) relations over time, the slope of the Phillips curve, the coeffi cients Figure 1 shows the evolution of , the weight of long-term on long-term infl ation expectations in the Phillips curve and on expectations in the Phillips curve. It shows how, after going lagged infl ation in the expectation equation, the intercept of the down in the 1970s, it has steadily gone up since the mid-1980s, expectation equation, and the natural rate of unemployment, are and is now close to one. Equivalently, the weight of past infl a- allowed to follow random walks. (Estimation is done using quar- tion, (1 – ), has steadily decreased over time. terly data since 1960. Data sources, and details of estimation for Figure 2 shows the evolution of t , the coeffi cient refl ecting the fi rst equation, are given in Blanchard, Cerutti, and Summers.) the eff ect of past infl ation on long-term expected infl ation. After Figure 1 The anchoring of expectations (λ) 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 Note: Dotted blue lines show +/–1 standard deviation. Source: Blanchard, Cerutti, and Summers (2015). Figure 2 The anchoring of long-term expectations (β) 0.30 0.25 0.20 0.15 0.10 0.05 0 –0.05 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 Note: Dotted blue lines show +/–1 standard deviation. Source: Data are from figure 1. 2 NUMBER PB16-1 JANUARY 2016 Figure 3 The decrease in the slope of the Phillips curve (θ) 1.2 1.0 0.8 0.6 0.4 0.2 0 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 Note: Dotted blue lines show +/–1 standard deviation. Source: Blanchard, Cerutti, and Summers (2015). increasing in the 1970s, it decreased in the 1980s, and has been the condition that keeping infl ation constant delivers the best close to zero since the late 1980s. unemployment rate policy can deliver. Figures 1 and 2 together suggest that infl ation now depends Results vary slightly, depending on the exact choice of mostly on long-term expected infl ation rather than past infl a- variables and the exact specifi cation. Some specifi cations, using tion, and that long-term expected infl ation in turn depends little diff erent measures of infl ation, give a slightly larger slope, a on past infl ation. Th is implies that the Phillips curve relation is slightly higher value for (see Ball and Mazumder 2011 and now close to a level-level relation, with the level of the infl ation Kiley 2015). But the three evolutions shown in the previous rate relative to stable long-term expected infl ation depending fi gures appear robust. Th ey have important implications for the on the level of the unemployment rate. conduct of monetary policy. Figure 3 shows the evolution of t , the slope of the Phillips curve. Th e slope increased from the 1960s until the late 1970s, THE END OF THE ACCELERATIONIST CURSE? then steadily decreased until the late 1980s and has remained roughly constant and low since then. Perhaps surprisingly, given One of the most dramatic implications of the accelerationist the relevance of an eff ective zero lower bound on nominal wage Phillips curve is that every boom must be followed by an equal decreases (Daly and Hobijn 2014), there is no evidence that the size bust. Or, more accurately, if infl ation is going to remain slope has decreased further in the crisis. Given expected infl a- constant in the long run, any negative unemployment gap must tion, a decrease in the unemployment rate led to an increase eventually be off set by an equal sum of positive unemployment in infl ation of 0.7 percent in the mid-1970s. Th e eff ect is now gaps later: closer to 0.2 percent. Various explanations have been off ered T for this evolution. Th e most convincing is that, as the level ()[()uu ()0] uu SStt 10 T S T S¦ (3) of infl ation has decreased, wages and prices are changed less 0 often, leading to a smaller response of infl ation to labor market Th is implication disappears when (1 – ), the coeffi cient conditions. (In the Calvo formalization of price stickiness, for on lagged infl ation, is less than one, and a fortiori when, as example, the slope coeffi cient is roughly proportional to p2, appears to be the case today, (1 – ) is close to zero. In this case, where p is the probability that a price will be changed in a given a boom will be associated with higher infl ation, but infl ation period.) will decrease as unemployment returns to the natural rate, and Th e last relevant result is that the fi t of the relation remains there is no need for the boom to be followed by a bust.