For release on delivery
12:45 p.m. EDT
October 2, 2018
Monetary Policy and Risk Management
at a
Time of Low Inflation and Low Unemployment
Remarks by
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
at the
"Revolution or Evolution? Reexamining Economic Paradigms"
60th Annual Meeting of the National Association for Business Economics
Boston, Massachusetts
October 2, 2018
It is a pleasure and an honor to speak here today at the 60th Annual Meeting of
the National Association for Business Economics (NABE). Since 1959, NABE has
promoted the use of economics in the workplace and advanced the worthy purpose of
ensuring that leading American businesses benefit from the insights of economists.
Today I will focus on the Federal Reserve's ongoing efforts to promote maximum
employment and stable prices. I am pleased to say that, by these measures, the economy
looks very good. The unemployment rate stands at 3.9 percent, near a 20-year low.
Inflation is currently running near the Federal Open Market Committee's (FOMC)
objective of 2 percent. While these two top-line statistics do not always present an
accurate picture of overall economic conditions, a wide range of data on jobs and prices
supports a positive view. In addition, many forecasters are predicting that these favorable
conditions are likely to continue. For example, the medians of the most recent
projections from FOMC participants and the Survey of Professional Forecasters, as well
as the most recent Congressional Budget Office (CBO) forecast, all have the
unemployment rate remaining below 4 percent through the end of 2020, with inflation
staying very near 2 percent over the same period.1
From the standpoint of our dual mandate, this is a remarkably positive outlook.
Indeed, I was asked at last week's press conference whether these forecasts are too good
to be true--a reasonable question! Since 1950, the U.S. economy has experienced periods
of low, stable inflation and periods of very low unemployment, but never both for such
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an extended time as is seen in these forecasts.2 Standard economic thinking has long
offered an explanation for this: If unemployment were to remain this low for this long,
employers would be pushing up wages as they compete for scarce workers, and rising
labor costs would feed into more-rapid price inflation faced by consumers.
This dynamic between unemployment and inflation is known as a Phillips curve
relationship, and at times it can pose a fundamental tension between the two sides of the
Fed's mandate to promote maximum employment and price stability. Recent low
inflation and unemployment have some analysts asking, "Is the Phillips curve dead?"3
Others argue that the Phillips curve still lurks in the background and could reemerge at
any time to exact revenge for low unemployment in the form of high inflation.
My comments today have two main objectives. The first is to explain how
changes in the Phillips curve help account for the somewhat surprising but broadly shared
current forecasts of continued very low unemployment with inflation near 2 percent. At
the risk of spoiling the surprise, I do not see it as likely that the Phillips curve is dead, or
that it will soon exact revenge. What is more likely, in my view, is that many factors,
including better conduct of monetary policy over the past few decades, have greatly
reduced, but not eliminated, the effects that tight labor markets have on inflation.
However, no one fully understands the nature of these changes or the role they play in the
- 3 -
current context. Common sense suggests we should beware when forecasts predict
events seldom before observed in the economy.4
Thus, my second objective today is to explain, given this uncertainty about the
unemployment-inflation relationship, the important role that risk management plays in
setting monetary policy. I will explore the FOMC's monitoring and balancing of risks as
well as our contingency planning for cases when risk becomes reality.
Historical Perspective on Jobs and Inflation
Let us start with a look at the modern history of jobs and inflation in the United
States. Figure 1 shows headline inflation and unemployment from 1960 to today and
extended through 2020 using the average of median projections from both FOMC
participants and the Survey of Professional Forecasters, and the CBO projections. As the
figure makes clear, a multiyear period with unemployment below 4 percent and stable
inflation would, if realized, be unique in modern U.S. data.5
To understand the basis for these forecasts, it is useful to contrast two very
different periods included in figure 1: From 1960 to 1985, and the period from 1995 to
today. The first period includes the Great Inflation, and the latter includes both the Great
Moderation and the distinctly immoderate period of the Global Financial Crisis and its
aftermath.
Figure 2 shows unemployment and core, rather than headline, inflation in these
two periods. While our inflation objective concerns headline inflation, switching to core
- 4 -
inflation makes some relationships clearer by removing a good deal of variability due to
food and energy prices, variability that is not primarily driven by labor market conditions
or monetary policy.
There is a dramatic difference in the unemployment-inflation relationship across
these two periods. During the Great Inflation, unemployment fluctuated between roughly
4 percent and 10 percent, and inflation moved over a similar range. In the recent period,
the unemployment rate also fluctuated between roughly 4 percent and 10 percent, but
inflation has been relatively tame, averaging 1.7 percent and never declining below
1 percent or rising to 2.5 percent. Even during the financial crisis, core inflation barely
budged. As a thought experiment, look at the right panel and imagine that you could see
only the red line (inflation), and not the blue line (unemployment). Nothing in the red
line hints at a major economic event, let alone the immense upheaval around the time of
the global financial crisis.
Notice that, in each period, there is only one episode in which unemployment
drops below 4 percent. In the late 1960s, unemployment remained at or below 4 percent
for four years, and during that time inflation rose steadily from under 2 percent to almost
5 percent. By contrast, the late 1990s episode of below-4-percent unemployment was
quite brief, and during the episode and surrounding quarters inflation was reasonably
stable and remained below 2 percent.
To explore the Phillips curve relationship in these two periods more closely, we
need to bring in the concept of the natural rate of unemployment. In standard economic
thinking, an unemployment rate above the natural rate indicates slack in the labor market
and tends to be associated with downward pressure on inflation; unemployment below
- 5 -
the natural rate represents a tight labor market and is associated with upward inflation
pressure.
Figure 3 repeats figure 2 but replaces unemployment with labor market slack as
measured by unemployment minus the CBO's current estimate of the natural rate of
unemployment at each point in time.6 Periods of tight labor markets are shaded. During
the Great Inflation, inflation generally rose in the tight, shaded periods and fell in the
unshaded ones, just as conventional Phillips curve reasoning predicts.
From 1995 to today, the large and persistent swings in the gap between
unemployment and the natural rate were associated with, at most, a move of a few tenths
in the inflation rate. Comparing the shaded and unshaded regions, you might see some
association between slack and the minor ups and downs in inflation, but the pattern is not
at all consistent. It is evidence like this that fuels speculation about the Phillips curve's
demise.
Whether dead, sick, or merely resting, many of the questions about the Phillips
curve come down to figuring out what changed between these two periods, and why. Let
us turn to a conceptual framework for examining these questions more systematically.
A Simple Framework for Understanding Changes in the Jobs-Inflation Relationship
A natural starting point is the simplest form of a Phillips curve equation, which
posits that inflation this year is determined by some combination of current labor market
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slack, inflation last year, and some other factors that I will leave aside for this discussion
(figure 4):7
Inflation(t) = -B Slack(t) + C Inflation(t - 1) + Other(t).
The value of B is often referred to as the slope of the Phillips curve. With a larger
value of B, any change in labor market slack translates into a bigger change in inflation.
As we say, as B increases, the Phillips curve steepens. The value of C determines
inflation's persistence--that is, how long any given change in inflation tends to linger. As
the value of C increases, higher inflation this year translates more into higher inflation
next year. A particularly nasty case arises when B and C are both large. In this case,
slack has a large effect on inflation, and that effect tends to be very persistent. One
implication of a large C is that, if a boom drives inflation up, it will tend to stay up unless
offset by a subsequent bust.8
Figure 5 shows regression estimates of B and C, computed over 20-year samples
starting with the sample from 1965 to 1984 and including each 20-year sample through
2017. During the Great Inflation samples, the value of C is near 1, meaning that higher
inflation one year tended to translate almost one-for-one into higher inflation the next.
The Phillips curve is also relatively steep in the Great Inflation samples, with 1 extra
percentage point of lower unemployment converting into roughly 1/2 percentage point of
higher inflation. Thus, the Great Inflation presented that nasty case just described.
- 7 -
Fortunately, things changed. The estimates of both B and C fall in value as the
estimation sample shifts forward in time. In the most recent samples, the Phillips curve is
nearly flat, with B very near zero, and C is about 0.25, meaning that roughly one fourth of
any rise or fall in inflation carries forward. These results give numerical form to what we
see in the right-hand panel of figure 3, covering the recent period: Large and persistent
moves in the unemployment gap were associated with, at most, modest transitory moves
in inflation.
What Led to the Changes in the Phillips curve?
These developments amount to a better world for households and businesses,
which no longer experience or even fear the scourge of high and volatile inflation. To
provide a sound basis for monetary policy, it is important to understand what happened
and why, so we can avoid a return to the bad old days of the 1970s. Like many, I believe
better monetary policy has played a central role.9
To understand the mechanism, let us ask how central banks could, presumably
inadvertently, amplify and extend the duration of inflation's response to labor market
tightness. To do so, the central bank could persistently ease the stance of monetary
policy in response to an uptick in inflation. No responsible central banker today would
intentionally do this, but much research suggests that during the Great Inflation,
misunderstandings about how the economy worked led the Fed effectively to behave in
this manner.10 Some policymakers may have believed the misguided notion that
- 8 -
accommodating permanently higher inflation could purchase permanently higher
employment.11 Other policymakers misperceived the level of the natural rate of
unemployment, which we now believe had shifted up markedly in the 1960s. With the
higher natural rate, the labor market was much tighter and provided much greater upward
pressure on inflation than policymakers realized in real time. As a result, they were
continually "behind the curve."12
The channel through which monetary policy can amplify and extend inflation's
response to shocks becomes even stronger when we take account of expectations. If
people come to expect that upward blips in inflation will result in ongoing higher
inflation, they will build that view into wage and price decisions. In this case, people's
expectations become a force adding momentum to inflation, and breaking inflation's
momentum can require convincing people to change their minds and behavior--never an
easy task. Arguably, this is why a federal funds rate near 20 percent--roughly 10 percent
in real terms--was required in the early 1980s to turn the tide on high inflation. The cost,
in the form of very high unemployment, is clear in the Great Inflation figures.
The Great Inflation taught us that a main task of monetary policy is to keep inflation
expectations anchored at some low level.
This idea is behind the adoption in recent decades of inflation targets, such as the
Fed's 2 percent objective, by central banks around the world. When monetary policy
tends to offset shocks to inflation, rather than amplifying and extending them, and when
people come to expect this policy response, a surprise rise or fall in labor market
tightness will naturally have smaller and less persistent effects on inflation. Research
- 9 -
suggests that this reasoning can account for a good deal of the change in the Phillips
curve relationship.13 It is also likely that many other factors have contributed to changes
in inflation dynamics over recent decades. We do not fully understand the causes and
implications of these changes, which raises risk management issues that I will take up
now.14
A Favorable Outlook, but What Could Go Wrong?
To set the stage, let us return to the situation facing the FOMC. The baseline
forecasts of most FOMC participants and a broad range of others show unemployment
remaining below 4 percent for an extended period, with inflation steady near 2 percent. I
have made the case that this forecast is not too good to be true and does not signal the
death of the Phillips curve. Instead, the outlook is consistent with evidence of a very flat
Phillips curve and inflation expectations anchored near 2 percent.
But we still must face the cautionary advice to beware when forecasts point to
rarely seen outcomes. As a way of heeding this advice, the Committee takes a risk
management approach, which has three important parts: monitoring risks; balancing
risks, both upside and downside; and contingency planning for surprises. Let me
describe a few of the risks and how we are thinking about them.
Could Inflation Expectations Become Unanchored?
First is the risk that inflation expectations might lose their anchor. We attribute a
great deal of the stability of inflation in recent years to the anchoring of longer-term
inflation expectations. And we are aware that it could be very costly if those expectations
were to drift materially. As you probably know from our public communications, we
carefully monitor survey- and market-based proxies for expectations, and we do not see
evidence of a material shift in longer-term expectations (figure 6). The survey measures
have been particularly steady for some time.15 The financial market-based measures
include both an expectations component and a volatile inflation premium component, so
they tend to move around much more than the surveys, but we see no evidence of a
material change in these measures, either.
The risks to inflation expectations are, of course, two sided. Until this summer,
inflation had remained stubbornly below 2 percent for several years. And major
economies in much of the world have been struggling mainly with disinflationary forces.
Thus, we have been and will remain alert for possible downward drift in expectations.
Some argue the contrary case--that by only gradually removing accommodation as the
unemployment rate has fallen, the FOMC may have fallen behind the curve, thereby
risking an upward drift in expectations. From the standpoint of contingency planning,
our course is clear: Resolutely conduct policy consistent with the FOMC's symmetric 2
percent inflation objective, and stand ready to act with authority if expectations drift
materially up or down.
Could Inflation Pressures Move up More than Expected in a Hot Economy?
A second risk is that labor market tightness or tightness in other parts of the
production chain might lead to higher inflation pressure than expected--the "revenge of
the Phillips curve" scenario.16 As I mentioned, the FOMC carefully monitors a wide
array of early indicators of inflation pressure to evaluate this risk. Wages and
compensation data are one important source of information. These measures have picked
up some recently, but in a way that is quite welcome. Specifically, the rise in wages is
broadly consistent with observed rates of price inflation and labor productivity growth
and therefore does not point to an overheating labor market. Further, higher wage growth
alone need not be inflationary. The late 1990s episode of low unemployment saw wages
rise faster than inflation plus productivity growth without an appreciable rise in inflation.
Despite what shows up in the aggregate wage and compensation data, however, I
am sure that, like us, many of you are hearing widespread anecdotes about labor
shortages and increasing bottlenecks in production. For example, as shown in figure 7,
the words "shortage" and "bottleneck" are increasingly appearing in the Beige Book, the
Federal Reserve's report summarizing discussions with our business contacts around the
country.17 The message we are hearing in our conversations is supported by a wide range
of more conventional measures. For example, the survey of members of the National
Federation of Independent Business finds firms increasingly reporting that job openings
are hard to fill (figure 8). Further, these businesses now list "quality of labor" as their
most important problem, as opposed to the more typical report of "poor sales."
We review a wide variety of measures of this type, and these indicators show
what I think most business people see: an economy operating with limited slack. Notice,
however, that these measures are near levels that prevailed in the late 1990s or early
2000s, a period when core inflation remained under 2 percent.
While the late 1990s case proves that elevated values of these tightness measures
do not automatically translate into rising inflation, a single episode provides only limited
reassurance. Thus, the FOMC takes seriously the possibility that tight markets for labor
or other inputs could provide greater upward pressure on inflation than in the baseline
outlook. Our best estimates, however, suggest that so long as inflation expectations
remain anchored, a modest steepening of the Phillips curve would be unlikely to cause a
significant rise in inflation or demand a disruptive policy tightening.18 Once again, the
key is the anchored expectations.
Is the Natural Rate of Unemployment Lower Than Expected?
A third risk--in this case an upside risk--is that the natural rate of unemployment
could be even lower than current estimates. Some have argued that the Fed should be
removing policy accommodation much more slowly, pushing the economy to see if the
natural rate of unemployment is lower still.
Advocates of this view note that over the past several years of policy
normalization, the economy has continued to strengthen and unemployment has fallen,
but inflation has remained quiet. As I discussed in a recent speech, many analysts have
accounted for the lack of rising inflation pressure by lowering their estimate of the natural
rate.19 For example, since the start of 2016, the unemployment rate has fallen about 1
percentage point, and estimates of the natural rate from four well-known sources have
fallen over that period between 0.3 percent and 0.7 percent (figure 9).
If the natural rate is now materially lower than we believe, that would imply less
upward pressure on inflation--the flip side of the "revenge of the Phillips curve" risk.
Our policy of gradual interest rate normalization represents the FOMC's attempt to take
both of these risks seriously. Removing accommodation too quickly could needlessly
foreshorten the expansion. Moving too slowly could risk rising inflation and inflation
expectations. Our path of gradually removing accommodation, while closely monitoring
the economy, is designed to balance these risks.
In wrapping up this discussion of risks to the favorable outlook, I should
emphasize that I have chosen to focus on three risks that are all associated with the
Phillips curve. There are, of course, myriad other risks. To name just a few, we must
consider the strength of economies abroad, the effects of ongoing trade disputes, and
financial stability issues. I hope my discussion of three particular risks gives a sense of
how we approach these issues.
Conclusion
Many of us have been looking back recently on the decade that has passed since
the depths of the financial crisis. In light of that experience, I am glad to be able to stand
here and say that the economy is strong, unemployment is near 50-year lows, and
inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside
and outside the Fed is for more of the same.
This historically rare pairing of steady, low inflation and very low unemployment
is testament to the fact that we remain in extraordinary times. Our ongoing policy of
gradual interest rate normalization reflects our efforts to balance the inevitable risks that
come with extraordinary times, so as to extend the current expansion, while maintaining
maximum employment and low and stable inflation.
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