Understanding the Evolving Inflation Process

This report uses international comparisons to understand U.S. inflation dynamics since 1960. We decompose each G-7 country’s inflation path into a time-varying trend plus a transitory component, each with time-varying volatility. The level and volatility of trend inflation display coincident hump-shaped patterns that allow us to date the start of the Great Inflation in the late 1960s and a synchronized Inflation Stabilization beginning in the mid 1980s. This temporal clustering narrows the set of G-7-wide economic developments which could have triggered the excessive monetary policy accommodation that was the ultimate source of the Great Inflation. We present evidence suggesting that the most likely explanation is a change in monetary regime. Another robust feature of the data is that changes in inflation are negatively serially correlated. Conventional versions of a workhorse macroeconomic model regularly used by central banks cannot account for this pattern. Finally, we show that in the United States neither survey nor other measures of inflation expectations provide useful forecasts of the estimated trend in U.S. core CPI inflation since the Inflation Stabilization two decades ago. Thus, measuring the effectiveness of policy may be challenging and care must be taken in assessing the risk of a return to volatile inflation. Understanding the Evolving Inflation Process U.S. Monetary Policy Forum 2007 ii February 2007 Executive Summary This report employs international comparisons to examine the evolution of U.S. inflation dynamics since 1960, and to draw simple policy conclusions to aid in keeping inflation low. We begin by decomposing each G-7 country’s inflation path into a time-varying trend and a transitory component, each with time-varying volatility. This exercise yields the following somewhat surprising result: The level and volatility of the inflation trend in each of the G-7 countries follows a hump-shaped pattern which rises and falls nearly in unison. This synchronization leads us to a data-driven dating of the Great Inflation (in the late 1960s), when inflation rose and became volatile, and of the Inflation Stabilization (around the mid-1980s), when inflation receded and steadied. This coincident timing: (1) narrows the set of G-7-wide economic developments that may have triggered the excessive policy accommodation of the Great Inflation; and (2) distinguishes the Inflation Stabilization from the Great Moderation of G-7 output growth volatility, which does not exhibit the same temporal clustering. We present evidence that several prominent explanations of the U.S. Great Inflation fall short. First, misestimates of the economy’s capacity appear insufficient to account for the scale and 15year duration of the Great Inflation. Combined with the availability of means to improve estimates of the economy’s deviation from potential, the fact that inflation remained so high for so long also casts doubt on the simplest policy learning models. Second, explanations relying on the evolution of policymaker understanding of the U.S. economy must be squared with the different paths followed in Germany and, to a lesser extent, Japan. The low estimated level and volatility of the inflation trend in these two countries highlights them as important outliers. Third, the Inflation Stabilization appears inconsistent with an “expectations trap” model: Even in the absence of a new policy “precommitment” mechanism, and despite overestimated sacrifice ratios, G-7 central bankers eventually acted to end the Great Inflation. Like other observers, we link the Great Inflation and Inflation Stabilization to changes in the monetary policy regimes of several G-7 countries. These regimes are represented by the deviations of policy interest rates from a simple Taylor rule. The deviations imply substantial accommodation throughout the Great Inflation era. Since macroeconomic models based on the New Keynesian Phillips Curve (NKPC) have become part of the standard policy evaluation toolkit in the major central banks, we examine the ability of a simple version of such a model to mimic a robust property of estimated G-7 inflation dynamics. With a standard calibration, the model cannot replicate the negative serial correlation of inflation changes that intensified after the Inflation Stabilization. Matching this feature of the data requires that we change key model parameters substantially, making interest rate shocks (those in the monetary policy reaction function) very small and assuming that price setters are nearly entirely forward looking. Finally, we study the relationship between the estimated trend of U.S. core CPI inflation and various measures of inflation expectations. From our results, we conclude that, since the Inflation Stabilization, none of the expectations measures helps to improve forecasts of the inflation trend. Understanding the Evolving Inflation Process U.S. Monetary Policy Forum 2007 iii February 2007 If anything, the estimated trend has become the leader, as it helps to forecast inflation expectations. This finding serves as a cautionary note for policymakers against excessive reliance on measures of inflation expectations as indicators of policy effectiveness. Overall, our results should temper any temptation on the part of monetary policymakers to exploit the low persistence of inflation that has been observed over the past decade. While our statistical model mimics the widely-touted drop of persistence since the Great Inflation ended, there is nothing structural about this change. Indeed, the policy regime analysis suggests that the current low persistence of inflation is itself a result of the rule-like policy behavior that has predominated since the 1980s. If the credibility dividend of the low-inflation era were to foster policy complacency in the face of unpleasant inflation news – or if perceptions of political interference in policy-setting were to arise – then the volatility of trend inflation could rebound. Understanding the Evolving Inflation Process U.S. Monetary Policy Forum 2007 1 February 2007 Table of