Janet L Yellen: Inflation dynamics and monetary policy
Speech by Ms Janet L Yellen, Chair of the Board of Governors of the Federal Reserve
System, at the Philip Gamble Memorial Lecture, University of Massachusetts, Amherst,
Massachusetts, 24 September 2015.
* * *
I would like to thank Michael Ash for his kind introduction and the University of
Massachusetts for the honor of being invited to deliver this year's Philip Gamble Memorial
Lecture.
In my remarks today, I will discuss inflation and its role in the Federal Reserve's conduct of
monetary policy. I will begin by reviewing the history of inflation in the United States since the
1960s, highlighting two key points: that inflation is now much more stable than it used to be,
and that it is currently running at a very low level. I will then consider the costs associated
with inflation, and why these costs suggest that the Federal Reserve should try to keep
inflation close to 2 percent. After briefly reviewing our policy actions since the financial crisis,
I will discuss the dynamics of inflation and their implications for the outlook and monetary
policy.
Historical review of inflation
A crucial responsibility of any central bank is to control inflation, the average rate of increase
in the prices of a broad group of goods and services. Keeping inflation stable at a moderately
low level is important because, for reasons I will discuss, inflation that is high, excessively
low, or unstable imposes significant costs on households and businesses. As a result,
inflation control is one half of the dual mandate that Congress has laid down for the Federal
Reserve, which is to pursue maximum employment and stable prices.
The Federal Reserve has not always been successful in fulfilling the price stability element of
its mandate. The dashed red line in figure 1 plots the four-quarter percent change in the price
index for personal consumption expenditures (PCE) - the measure of inflation that the Fed's
policymaking body, the Federal Open Market Committee, or FOMC, uses to define its
longerrun inflation goal.1 Starting in the mid-1960s, inflation began to move higher. Large jumps in
food and energy prices played a role in this upward move, but they were not the whole story,
for, as illustrated here, inflation was already moving up before the food and energy shocks hit
in the 1970s and the early 1980s.2 And if we look at core inflation, the solid black line, which
excludes food and energy prices, we see that it too starts to move higher in the mid-1960s
and rises to very elevated levels during the 1970s, which strongly suggests that something
more than the energy and food price shocks must have been at work.
A second important feature of inflation over this period can be seen if we examine an
estimate of its long-term trend, which is plotted as the dotted black line in figure 1. At each
point in time, this trend is defined as the prediction from a statistical model of the level to
which inflation is projected to return in the long run once the effects of any shocks to the
economy have fully played out.3 As can be seen from the figure, this estimated trend drifts
higher over the 1960s and 1970s, implying that during this period there was no stable
"anchor" to which inflation could be expected to eventually return - a conclusion generally
supported by other procedures for estimating trend inflation.
Today many economists believe that these features of inflation in the late 1960s and
1970s - its high level and lack of a stable anchor - reflected a combination of factors,
including chronically overheated labor and product markets, the effects of the energy and
food price shocks, and the emergence of an "inflationary psychology" whereby a rise in
actual inflation led people to revise up their expectations for future inflation. Together, these
various factors caused inflation - actual and expected - to ratchet higher over time.
Ultimately, however, monetary policy bears responsibility for the broad contour of what
happened to actual and expected inflation during this period because the Federal Reserve
was insufficiently focused on returning inflation to a predictable, low level following the
shocks to food and energy prices and other disturbances.
In late 1979, the Federal Reserve began significantly tightening monetary policy to reduce
inflation. In response to this tightening, which precipitated a severe economic downturn in the
early 1980s, overall inflation moved persistently lower, averaging less than 4 percent from
1983 to 1990. Inflation came down further following the 1990-91 recession and subsequent
slow recovery and then averaged about 2 percent for many years. Since the recession ended
in 2009, however, the United States has experienced inflation running appreciably below the
FOMC's 2 percent objective, in part reflecting the gradual pace of the subsequent economic
recovery.
Examining the behavior of inflation's estimated long-term trend reveals another important
change in inflation dynamics. With the caveat that these results are based on a specific
implementation of a particular statistical model, they imply that since the mid-1990s there
have been no persistent movements in this predicted long-run inflation rate, which has
remained very close to 2 percent. Remarkably, this stability is estimated to have continued
during and after the recent severe recession, which saw the unemployment rate rise to levels
comparable to those seen during the 1981-82 downturn, when the trend did shift down
markedly.4 As I will discuss, the stability of this trend appears linked to a change in the
behavior of long-run inflation expectations - measures of which appear to be much better
anchored today than in the past, likely reflecting an improvement in the conduct of monetary
policy. In any event, this empirical analysis implies that, over the past 20 years, inflation has
been much more predictable over the longer term than it was back in the 1970s because the
trend rate to which inflation was predicted to return no longer moved around appreciably.
That said, inflation still varied considerably from year to year in response to various shocks.
As figure 2 highlights, the United States has experienced very low inflation on average since
the financial crisis, in part reflecting persistent economic weakness that has proven difficult to
fully counter with monetary policy. Overall inflation (shown as the dashed red line) has
averaged only about 1-1/2 percent per year since 2008 and is currently close to zero. This
result is not merely a product of falling energy prices, as core inflation (the solid black line)
has also been low on average over this period.
Inflation costs
In 2012 the FOMC adopted, for the first time, an explicit longer-run inflation objective of
2 percent as measured by the PCE price index.5 (Other central banks, including the
European Central Bank and the Bank of England, also have a 2 percent inflation target.) This
decision reflected the FOMC's judgment that inflation that persistently deviates - up or down
- from a fixed low level can be costly in a number of ways. Persistent high inflation induces
households and firms to spend time and effort trying to minimize their cash holdings and
forces businesses to adjust prices more frequently than would otherwise be necessary. More
importantly, high inflation also tends to raise the after-tax cost of capital, thereby
discouraging business investment. These adverse effects occur because capital depreciation
allowances and other aspects of our tax system are only partially indexed for inflation.6
Persistently high inflation, if unanticipated, can be especially costly for households that rely
on pensions, annuities, and long-term bonds to provide a significant portion of their
retirement income. Because the income provided by these assets is typically fixed in nominal
terms, its real purchasing power may decline surprisingly quickly if inflation turns out to be
consistently higher than originally anticipated, with potentially serious consequences for
retirees' standard of living as they age.7
An unexpected rise in inflation also tends to reduce the real purchasing power of labor
income for a time because nominal wages and salaries are generally slow to adjust to
movements in the overall level of prices. Survey data suggest that this effect is probably the
number one reason why people dislike inflation so much.8 In the longer run, however, real
wages - that is, wages adjusted for inflation - appear to be largely independent of the
average rate of inflation and instead are primarily determined by productivity, global
competition, and other nonmonetary factors. In support of this view, figure 3 shows that
nominal wage growth tends to broadly track price inflation over long periods of time.
Inflation that is persistently very low can also be costly, and it is such costs that have been
particularly relevant to monetary policymakers in recent years. The most important cost is
that very low inflation constrains a central bank's ability to combat recessions. Normally, the
FOMC fights economic downturns by reducing the nominal federal funds rate, the rate
charged by banks to lend to each other overnight. These reductions, current and expected,
stimulate spending and hiring by lowering longer-term real interest rates - that is, nominal
5
In contrast, the FOMC has determined that a number of considerations preclude it from setting a fixed
numerical target for the other leg of its dual mandate, maximum employment. As discussed in its Statement on
Longer-Run Goals and Monetary Policy Strategy (see note 1), the maximum level of employment is something
that is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.
Moreover, the maximum level of employment, the longer-run "natural" rate of unemployment, and other related
aspects of the labor market are not directly observable, can change over time, and can only be estimated
imprecisely. As a result, views vary about what labor market conditions would be consistent with a normal
level of resource utilization.
6
For a general survey of the costs of high inflation, see Briault (1995). English (1999) discusses costs
associated with an increased need for cash management. For a discussion of costs that arise through
interactions of inflation with the tax system, see Feldstein (1997, 1999) and Cohen and others (1999). Finally,
high inflation may adversely affect the economy's allocation of resources by increasing the magnitude of
misalignments in relative prices that result because firms do not continually adjust all of their prices; for a
discussion of such costs in the context of the new-Keynesian model of inflation, see Ascari and Sbordone
(2014).
7
More broadly, if inflation evolves in an unpredictable manner over many years, then even financially
sophisticated households and firms may not be able to avoid significant forecasting errors with their attendant
costs. Such costs can arise in a wide variety of situations; for instance, any firm, union, or other entity that
engages in a multiyear nominal contract may be adversely affected by unexpected increases or decreases in
inflation, although those on the other side of the contract might benefit.
8
For more on this survey, see Shiller (1997).
rates adjusted for inflation - and improving financial conditions more broadly. But the federal
funds rate and other nominal interest rates cannot go much below zero, since holding cash is
always an alternative to investing in securities.9 Thus, the lowest the FOMC can feasibly
push the real federal funds rate is essentially the negative value of the inflation rate. As a
result, the Federal Reserve has less room to ease monetary policy when inflation is very low.
This limitation is a potentially serious problem because severe downturns such as the Great
Recession may require pushing real interest rates far below zero for an extended period to
restore full employment at a satisfactory pace.10 For this reason, pursuing too low an inflation
objective or otherwise tolerating persistently very low inflation would be inconsistent with the
other leg of the FOMC's mandate, to promote maximum employment.11
An unexpected decline in inflation that is sizable and persistent can also be costly because it
increases the debt burdens of borrowers. Consider homeowners who take out a conventional
fixed-rate mortgage, with the expectation that inflation will remain close to 2 percent and their
nominal incomes will rise about 4 percent per year. If the economy were instead to
experience chronic mild deflation accompanied by flat or declining nominal incomes, then
after a few years the homeowners might find it noticeably more difficult to cover their monthly
mortgage payments than they had originally anticipated. Moreover, if house prices fall in line
with consumer prices rather than rising as expected, then the equity in their home will be
lower than they had anticipated. This situation, which is sometimes referred to as "debt
deflation," would also confront all households with outstanding student loans, auto loans, or
credit card debt, as well as businesses that had taken out bank loans or issued bonds.12 Of
course, in this situation, lenders would be receiving more real income. But the net effect on
the economy is likely to be negative, in large part because borrowers typically have only a
limited ability to absorb losses. And if the increased debt-service burdens and declines in
collateral values are severe enough to force borrowers into bankruptcy, then the resultant
hardship imposed on families, small business owners, and laid-off workers may be very
severe.13
9
Because of the inconvenience of storing and protecting very large quantities of currency, some firms are
willing to pay a premium to hold short-term government securities or bank deposits instead. As a result,
several foreign central banks have found it possible to push nominal short-term interest rates somewhat below
zero.
10
For example, Curdia and others (2014) estimate that stabilizing the economy during the last recession would
have required lowering the real federal funds rate to negative 10 percent for a time; by comparison, the
average value of the real federal funds has been only negative 1-1/4 percent since early 2009. Of course, the
FOMC was able to use other policy tools, such as large-scale asset purchases, to put additional downward
pressure on long-term interest rates after the nominal funds rate was cut to near zero; however, those policies
had potential costs and risks that made them an imperfect substitute for traditional interest rate policy. See
Krugman (1998), Reifschneider and Williams (2000), and Eggertsson and Woodford (2003) for discussions of
the effects that low inflation and the zero lower bound on nominal interest rates have on a central bank's ability
to stimulate the economy during economic downturns. In addition, see English, Lopez-Salido, and Tetlow
(2015) and Engen, Laubach, and Reifschneider (2015) for model-based analyses of the effectiveness of the
Federal Reserve's large-scale asset purchases and forward guidance in mitigating the effects of the zero
lower bound. Finally, for a discussion of the costs and benefits of employing large scale asset purchases, see
Bernanke (2012) and Yellen (2013).
11
For a further discussion of this point, see Mishkin (2007).
12
See Fisher (1933) for an early discussion of debt deflation and its effects on the economy.
13
Very low inflation also can result in chronically higher unemployment by closing off an important way in which
the labor market can respond to adverse shocks. In sectors where productivity is lagging or demand is
slowing, declines in real wages might be necessary to avoid even worse outcomes, such as layoffs. For
various reasons, however, employers often try to avoid nominal wage cuts. (Bewley (1999) suggests a
number of reasons that firms find cutting nominal wages difficult, including the effect that such cuts have on
employee morale. Inflation is therefore often said to "grease the wheels of the labor market" because it permits
these required adjustments in real wages to occur through a combination of unchanged nominal wages and
rising prices.) But when inflation falls to a very low level, this passive approach to wage reductions may no
longer be viable for many firms, causing relatively more of the burden of adjustment to fall on employment.
Monetary policy actions since the financial crisis
As I noted earlier, after weighing the costs associated with various rates of inflation, the
FOMC decided that 2 percent inflation is an appropriate operational definition of its
longerrun price objective.14 In the wake of the 2008 financial crisis, however, achieving both this
objective and full employment (the other leg of the Federal Reserve's dual mandate) has
been difficult, as shown in figure 4. Initially, the unemployment rate (the solid black line)
soared and inflation (the dashed red line) fell sharply. Moreover, after the recession officially
ended in 2009, the subsequent recovery was significantly slowed by a variety of persistent
headwinds, including households with underwater mortgages and high debt burdens,
reduced access to credit for many potential borrowers, constrained spending by state and
local governments, and weakened foreign growth prospects. In an effort to return
employment and inflation to levels consistent with the Federal Reserve's dual mandate, the
FOMC took a variety of unprecedented actions to help lower longer-term interest rates,
including reducing the federal funds rate (the dotted black line) to near zero, communicating
to the public that short-term interest rates would likely stay exceptionally low for some time,
and buying large quantities of longer-term Treasury debt and agency-issued
mortgagebacked securities.15
These actions contributed to highly accommodative financial conditions, thereby helping to
bring about a considerable improvement in labor market conditions over time. The
unemployment rate, which peaked at 10 percent in 2009, is now 5.1 percent, slightly above
the median of FOMC participants' current estimates of its longer-run normal level. Although
other indicators suggest that the unemployment rate currently understates how much slack
remains in the labor market, on balance the economy is no longer far away from full
employment. In contrast, inflation has continued to run below the Committee's objective over
the past several years, and over the past 12 months it has been essentially zero.
Nevertheless, the Committee expects that inflation will gradually return to 2 percent over the
next two or three years. I will now turn to the determinants of inflation and the factors that
underlie this expectation.
14
Blanchard, Dell'Ariccia and Mauro (2010), among others, have recently suggested that central banks should
consider raising their inflation targets, on the grounds that conditions since the financial crisis have
demonstrated that monetary policy is more constrained by the effective lower bound (ELB) on nominal interest
rates than was originally estimated. Ball (2013), for example, has proposed 4 percent as a more appropriate
target for the FOMC. While it is certainly true that earlier analyses of ELB costs significantly underestimated
the likelihood of severe recessions and slow recoveries of the sort recently experienced in the United States
and elsewhere (see Chung and others, 2012), it is also the case that these analyses did not take into account
central banks' ability to use large-scale asset purchases and other unconventional tools to mitigate the costs
arising from the ELB constraint. In addition, it is not obvious that a modestly higher target rate of inflation
would have greatly increased the Federal Reserve's ability to support real activity in the special conditions that
prevailed in the wake of the financial crisis, when some of the channels through which lower interest rates
stimulate aggregate spending, such as housing construction, were probably attenuated. Beyond these tactical
considerations, however, changing the FOMC's long-run inflation objective would risk calling into question the
FOMC's commitment to stabilizing inflation at any level because it might lead people to suspect that the target
could be changed opportunistically in the future. If so, then the key benefits of stable inflation expectations
discussed below - an increased ability of monetary policy to fight economic downturns without sacrificing price
stability - might be lost. Moreover, if the purpose of a higher inflation target is to increase the ability of central
banks to deal with the severe recessions that follow financial crises, then a better strategic approach might be
to rely on more vigorous supervisory and macroprudential policies to reduce the likelihood of such events.
Finally, targeting inflation in the vicinity of 4 percent or higher would stretch the meaning of "stable prices" in
the Federal Reserve Act.
15
For a more complete listing of the Federal Reserve's policy actions in recent years, see "The Federal
Reserve's Response to the Financial Crisis and Action to Foster Maximum Employment and Price Stability," a
webpage available on the Board's website. Also see Engen, Laubach, and Reifschneider (2015) for an
analysis of the combined macroeconomic effects of the FOMC's asset purchases and guidance concerning
the future path of the federal funds rate.
Inflation dynamics
Models used to describe and predict inflation commonly distinguish between changes in food
and energy prices - which enter into total inflation - and movements in the prices of other
goods and services - that is, core inflation. This decomposition is useful because food and
energy prices can be extremely volatile, with fluctuations that often depend on factors that
are beyond the influence of monetary policy, such as technological or political developments
(in the case of energy prices) or weather or disease (in the case of food prices). As a result,
core inflation usually provides a better indicator than total inflation of where total inflation is
headed in the medium term.16 Of course, food and energy account for a significant portion of
household budgets, so the Federal Reserve's inflation objective is defined in terms of the
overall change in consumer prices.
What, then, determines core inflation? Recalling figure 1, core inflation tends to fluctuate
around a longer-term trend that now is essentially stable. Let me first focus on these
fluctuations before turning to the trend. Economic theory suggests, and empirical analysis
confirms, that such deviations of inflation from trend depend partly on the intensity of
resource utilization in the economy - as approximated, for example, by the gap between the
actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross
domestic product (GDP) from potential output. This relationship - which likely reflects,
among other things, a tendency for firms' costs to rise as utilization rates increase -
represents an important channel through which monetary policy influences inflation over the
medium term, although in practice the influence is modest and gradual. Movements in certain
types of input costs, particularly changes in the price of imported goods, also can cause core
inflation to deviate noticeably from its trend, sometimes by a marked amount from year to
year.17 Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year,
variability of inflation is attributable to idiosyncratic and often unpredictable shocks.18
What about the determinants of inflation's longer-term trend? Here, it is instructive to
compare the purely statistical estimate of the trend rate of future inflation shown earlier in
figure 1 with survey measures of people's actual expectations of long-run inflation, as is done
in figure 5. Theory suggests that inflation expectations - which presumably are linked to the
central bank's inflation goal - should play an important role in actual price setting.19 Indeed,
the contours of these series are strikingly similar, which suggests that the estimated trend in
inflation is in fact related to households' and firms' long-run inflation expectations.20
16
Several other approaches are commonly used to abstract from the short-term volatility of overall inflation and
thereby better discern its medium-term direction. For example, one procedure removes the components of the
total PCE price index with the largest or smallest price changes before computing the average price change,
yielding the "trimmed mean" PCE index; another uses the median price change in a given period, rather than
the mean change, to represent the overall inflation rate. In practice, simply using core inflation does about as
well in predicting overall inflation over the coming year and beyond as these alternative procedures (see
Detmeister, 2011, 2012).
17
Another input cost that can affect core inflation is the price of energy; in recent decades, however, the
passthrough of energy price changes to core inflation appears much smaller than in previous periods (see Hooker,
2002; Clark and Terry, 2010).
18
Some of these idiosyncratic shocks are related to identifiable factors, such as changes in Medicare
reimbursement rates or movements in the (imputed) price of holding a checking account. (Both of these
factors are included in the services component of the PCE price index, but not the consumer price index
(CPI).) However, not all idiosyncratic shocks can be reliably traced to specific factors, as a significant fraction
represents unpredictable "noise."
19
Most theoretical versions of the Phillips curve suggest that inflation should depend on short-run inflation
expectations, but, as an empirical matter, measures of long-run expectations appear to explain the data better.
20
See Clark and Davig (2008); see also Faust and Wright (2013), who make a related point in the context of
inflation forecasting. Note that the question about expected inflation in the University of Michigan Surveys of
To summarize, this analysis suggests that economic slack, changes in imported goods
prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend
that is ultimately determined by long-run inflation expectations. As some will recognize, this
model of core inflation is a variant of a theoretical model that is commonly referred to as an
expectations-augmented Phillips curve.21 Total inflation in turn reflects movements in core
inflation, combined with changes in the prices of food and energy.
An important feature of this model of inflation dynamics is that the overall effect that
variations in resource utilization, import prices, and other factors will have on inflation
depends crucially on whether these influences also affect long-run inflation expectations.
Figure 6 illustrates this point with a stylized example of the inflation consequences of a
gradual increase in the level of import prices - perhaps occurring in response to stronger real
activity abroad or a fall in the exchange value of the dollar - that causes the rate of change of
import prices to be elevated for a time.22 First, consider the situation shown in panel A, in
which households' and firms' expectations of inflation are not solidly anchored, but instead
adjust in response to the rates of inflation that are actually observed.23 Such conditions
- which arguably prevailed in the United States from the 1970s to the mid-1990s - could
plausibly arise if the central bank has, in the past, allowed significant and persistent
movements in inflation to occur. In this case, the temporary rise in the rate of change of
import prices results in a permanent increase in inflation. This shift occurs because the initial
increase in inflation generated by a period of rising import prices leads households and firms
to revise up their expectations of future inflation. A permanent rise in inflation would also
result from a sustained rise in the level of oil prices or a temporary increase in resource
utilization.
By contrast, suppose that inflation expectations are instead well anchored, perhaps because
the central bank has been successful over time in keeping inflation near some specified
target and has made it clear to the public that it intends to continue to do so. Then the
response of inflation to a temporary increase in the rate of change of import prices or any
other transitory shock will resemble the pattern shown in panel B. In this case, inflation will
deviate from its longer-term level only as long as import prices are rising. But once they level
out, inflation will fall back to its previous trend in the absence of other disturbances.24
A key implication of these two examples is that the presence of well-anchored inflation
expectations greatly enhances a central bank's ability to pursue both of its objectives -
namely, price stability and full employment. Because temporary shifts in the rate of change of
import prices or other transitory shocks have no permanent influence on expectations, they
have only a transitory effect on inflation. As a result, the central bank can "look through" such
Consumers is not phrased in terms of a specific measure of prices, so its level - as opposed to its contour -
cannot be directly compared with a particular measure of inflation such as the change in the PCE price index.
21
See Tobin (1972) and Friedman (1968) for early discussions of the theory underpinning the
expectationsaugmented Phillips curve. Theoretical descriptions of the inflation process remain an active area of research in
economics. In recent years, many economic theorists have used a so-called new-Keynesian framework - in
which optimizing agents are assumed to face constraints on price or wage setting in the form of adjustment
costs or explicit nominal contracts - to model inflation dynamics (see Woodford, 2003, chapter 3, for a
textbook treatment). Although these new-Keynesian inflation models can differ importantly in their specifics,
they all tend to assign a central role to inflation expectations and resource utilization as drivers of inflation
dynamics.
22
In this exercise, we ignore any inflation effects that might arise because of shifts in resource utilization induced
by the change in import prices, which are expressed relative to core prices.
23
An expectations-augmented Phillips curve in which expectations of inflation are assumed to eventually
respond one-for-one to actual past inflation is typically referred to as an accelerationist Phillips curve.
24
Qualitatively similar results obtain in fully specified structural models with rational expectations - including the
FRB/US, EDO, and SIGMA models maintained at the Federal Reserve Board - in which the long-term
behavior of inflation and inflation expectations is governed by the central bank's (fixed) inflation objective.
short-run inflationary disturbances in setting monetary policy, allowing it to focus on returning
the economy to full employment without placing price stability at risk. Indeed, the Federal
Reserve has done just that in setting monetary policy over the past decade or more.
Moreover, as I will discuss shortly, these inflation dynamics are a key reason why the FOMC
expects inflation to return to 2 percent over the next few years.
On balance, the evidence suggests that inflation expectations are in fact well anchored at
present. Figure 7 plots the two survey measures of longer-term expected inflation I presented
earlier, along with a measure of longer-term inflation compensation derived as the difference
between yields on nominal Treasury securities and inflation-indexed ones, called TIPS. Since
the late 1990s, survey measures of longer-term inflation expectations have been quite stable;
this stability has persisted in recent years despite a deep recession and concerns expressed
by some observers regarding the potential inflationary effects of unconventional monetary
policy. The fact that these survey measures appear to have remained anchored at about the
same levels that prevailed prior to the recession suggests that, once the economy has
returned to full employment (and absent any other shocks), core inflation should return to its
pre-recession average level of about 2 percent.
This conclusion is tempered somewhat by recent movements in longer-run inflation
compensation, which in principle could reflect changes in investors' expectations for long-run
inflation. This measure is now noticeably lower than in the years just prior to the financial
crisi