Donald L Kohn: Lessons for central bankers from a Phillips Curve
Framework
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Boston's Annual Economic Conference
"Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve
Retrospective", Chatham, Massachusetts, 11 June 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
An economic model of inflation is an indispensable input to monetary policy deliberations. A
model in the Phillips curve tradition remains at the core of how most academic researchers
and policymakers - including this one - think about fluctuations in inflation; indeed,
alternative frameworks seem to lack solid economic foundations and empirical support. But
the modern Phillips curve differs substantially from versions in use several decades ago;
policymakers and academics alike are now attuned to the importance of expectations, the
possibility of structural change, and the uncertainty that surrounds our understanding of the
dynamics of wage and price adjustment. Moreover, the link between inflation and resource
utilization often emphasized in a Phillips curve framework accounts for only a modest part of
inflation fluctuations. My comments today will focus on how the lessons from recent research
on the Phillips curve are helping me think about the influence of fluctuations in the prices of
commodities, such as oil, on the outlook for inflation and the appropriate policy responses to
such developments.1
Policy objectives and a framework for analyzing inflation fluctuations
The Federal Reserve has been charged with the pursuit of price stability and maximum
employment. Price stability is uniquely in the control of the central bank over long periods,
and it is a prerequisite for the economy performing efficiently over time. The welfare costs of
inflation result from many factors: the potential costs to households and firms that result from
efforts to insure themselves against inflation or from confusion regarding real and nominal
prices; distortions to the financial system related to inflation; imperfect indexation of the
taxation, especially of capital income, and the related distortions to economic activity; and the
costs associated with a slow adjustment of nominal prices and wages. The costs of inflation
imply that central banks should aim for low measured inflation. Moreover, many of the costs
of inflation - such as those associated with misconceptions regarding inflation, efforts to
insure against inflation, and distortions to the financial system - are associated with the rate
of change in the entire set of prices of goods and services facing households or firms,
suggesting that measured inflation should be gauged by the rate of change in a broad set of
prices. Accordingly, the Federal Open Market Committee (FOMC) has been emphasizing
that it gauges price stability over the long-term by the behavior of the overall personal
consumption expenditures price index.
The economic framework that helps me think about fluctuations in inflation is based on the
substantial body of research on models of price dynamics that has been developed over the
past five decades. At its heart, the framework is based on the importance of sluggish
adjustment in (some) nominal wages and prices to changing economic conditions. This
sluggishness undoubtedly reflects a number of factors, which include the costs of adjusting
some nominal prices and wages, imperfect information regarding shifts in economic
conditions, and learning by firms and households about the structure of the economy,
including the setting of monetary policy.
Regardless of its source, the presence of sluggish nominal adjustment brings to the fore
three key elements driving wage and price dynamics: inflation expectations, supply shocks,
and resource utilization. Because some prices and wages are adjusted only infrequently,
both firms and households anticipate the future erosion of real prices and wages by
incorporating the expectations they have for inflation into their current price settings and
wage demands. As a result, inflation expectations play a critical role in the formation of
monetary policy. Moreover, the tendency of some prices to adjust very quickly to changing
circumstances in conjunction with sluggish adjustment in other prices and wages implies that
large, sharp price movements, such as a change in the price of oil, lead to relative price
distortions throughout the economy; these distortions imply that relative price shocks have
important implications for the functioning of the economy.2 Finally, fluctuations in resource
utilization, through their effects on the costs of production and on firms' desired markups over
these costs, are a significant determinant of price and wage decisions. The link from
resource utilization to inflation provides a major channel through which monetary policy
settings influence inflation: Adjustments in the policy interest rate bring about changes in
resource utilization, which then influence current and expected inflation.
Inflation forecasting and commodity price shocks
The economic outlook is the prime focus of monetary policy. Because the stance of policy
influences economic activity and inflation only with a lag, policymakers must adjust policy to
minimize the costs from fluctuations in activity and inflation in the future. The Phillips curve
framework is an important input into the forecast for inflation. I will focus specifically on how a
shock to the price of oil affects the inflation outlook within this framework. This topic is
especially salient of late - commodities prices in general, and perhaps most glaringly the
price of oil, have risen sharply over the past year; indeed, oil prices have risen sharply for
more than four years.
Consider a sharp rise in the price of oil that primarily reflects a shift in the balance between
demand and supply in the global market for oil.3 In the first instance, higher oil prices lead to
an increase in the overall level of consumer prices. When thinking about the outlook for
future inflation, it is useful to distinguish between oil and other prices. The most significant
factor determining oil prices is the current and prospective balance between demand and
supply. The aggregate behavior of most other prices, consisting of a large set of nominal
prices and wages that adjust slowly, is driven by the factors that enter the Phillips curve -
inflation expectations, resource utilization, and supply shocks (in this case, a shock to the
price of oil).
In a forecasting context, the Phillips curve framework motivates reduced-form regressions of
the rate of inflation for consumer prices excluding food and energy against proxies for each
key factor. Lagged values of inflation typically proxy for inflation expectations. The deviation
of output from potential or of the unemployment rate from its sustainable rate serves as a
proxy for resource utilization. And changes in relative prices for energy, food and imports are
traditionally included as measures of supply shocks.4 This type of regression is among the
most useful tools for forecasting inflation. Nonetheless, its forecast record is far from
spotless, and hence I consider the forecasts from such regressions as just one input that
helps inform my outlook for inflation.
The results of such exercises imply that, over recent history, a sharp jump in oil prices
appears to have had only modest effects on the future rate of inflation. This result likely
reflects two factors. First, commodities like oil represent only a small share of the overall
costs of production, implying that the magnitude of the direct pass-through from changes in
such prices to other prices should be modest, all else equal. Second, inflation expectations
have been well anchored in recent years, contributing to a muted response of inflation to oil
price shocks. But the anchoring of expectations cannot be taken as given; indeed, the type of
empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to
the last two decades, a period in which inflation expectations were not as well anchored as
they are today.5
Of course, oil prices have jumped repeatedly in recent years. The (relatively) continuous rise
in energy prices since 2003 has been a surprise to me and to most others, as least as best
as I can gauge by looking at prices that have been embedded in futures contracts over this
period. These contracts currently suggest that the price of oil will flatten out in the period
ahead.
Nonetheless, repeated increases in energy prices and their effect on overall inflation have
contributed to a rise in the year-ahead inflation expectations of households, especially this
year. Of greater concern is that some measures of longer-term inflation expectations appear
to have edged up since last year. Any tendency for these longer-term inflation expectations
to drift higher or even to fail to reverse over time would have troublesome implications for the
outlook for inflation.
The structural Phillips Curve, commodity price shocks, and monetary policy
The central role of inflation expectations implies that policymakers must look beyond this
type of reduced-form exercise for guidance. After all, the lags of inflation in reduced-form
regressions are a very imperfect proxy for inflation expectations. As emphasized in Robert
Lucas's critique of reduced-form Phillips curves more than 30 years ago, structural models
are needed to have confidence in the effect of any shock on the outlook for inflation and
economic activity.6
4
The amount of related literature is large. The article by Robert Gordon (1998) represents a good example and
is relevant when considering the notion of supply shocks generally. Stock and Watson (1999) present a broad
interpretation of the empirical Phillips curve in which a large number of macroeconomic indicators are used to
forecast inflation.
5
These factors are not the only two that have contributed to a lower effect of oil prices on inflation. For
example, the energy intensity of the economy has fallen over time. Research like that in Hooker (2002) and
subsequent work has discussed various possibilities in more detail. Blanchard and Gali (2007) suggest that
the seemingly muted affect of changes in the price of oil and inflation in recent years has been the result of
falling energy intensity, more flexible labor markets, better monetary policy, and good luck.
6
See Lucas (1976). Robert Lucas had emphasized the importance of structural models of the Phillips curve
well before his 1976 article; for example, see his contribution at the conference on wage and price dynamics
held at the Federal Reserve in 1970 (Lucas, 1972). Michael Woodford (1994) presented an important critique
of some research on commodity prices, inflation, and monetary policy in which the role of the Lucas critique
was central: In particular, he re-emphasized that a tendency of commodity prices to forecast inflation may not
be structural and could break down under alternative policy regimes - a tendency that seemed to be
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The importance of structural relationships as inputs to the monetary policy process poses a
challenge; for instance, there are many "structural" models of nominal price and wage
adjustment, each of these models emphasizes different frictions or imperfections and
therefore can have different policy implications, and empirical work has reached different
conclusions regarding the merits of alternative models.7 As a result, policymakers must look
to lessons that are common across alternative specifications and base policy on our current
understanding of the most likely important structural factors. Fortunately, I think that many of
the models of nominal price and wage adjustment imply similar conclusions regarding the
influence of commodity prices on the inflation outlook and the appropriate response of
monetary policy.
I will again focus on a sharp jump in the price of oil, reflecting supply and demand in the
market for oil. Because many nominal prices and wages are costly and slow to adjust, the
efficient allocation of resources is impeded during a transition period in which relative price
signals are distorted. For example, the prices of energy-intensive goods need to rise relative
to those of less-energy-intensive goods, but this adjustment follows a gradual and
asynchronous pattern. Similarly, the equilibrium real wage - the relative price of labor - will
tend to be depressed by an oil price shock due to the accompanying adverse movements in
the terms of trade and reduction in labor productivity, but the needed wage or price
adjustments proceed gradually.8 An efficient monetary policy should attempt to facilitate the
needed economic adjustments so as to minimize distortions to economic efficiency on the
path to achieving, over time, its dual objectives of price stability and maximum employment.9
In particular, an appropriate monetary policy following a jump in the price of oil will allow, on
a temporary basis, both some increase in unemployment and some increase in price
inflation. By pursuing actions that balance the deleterious effects of oil prices on both
employment and inflation over the near term, policymakers are, in essence, attempting to
find their preferred point on the activity/inflation variance-tradeoff curve introduced by John
Taylor 30 years ago.10 Such policy actions promote the efficient adjustment of relative prices:
Since real wages need to fall and both prices and wages adjust slowly, the efficient
adjustment of relative prices will tend to include a bit of additional price inflation and a bit of
additional unemployment for a time, leading to increases in real wages that are temporarily
below the trend established by productivity gains.
I should emphasize that the course of policy I have just described has taken inflation
expectations as given. In practice, it is very important to ensure that policy actions anchor
inflation expectations. This anchoring is critical: As demonstrated by historical experiences
around the world and in the United States during the 1970s and 1980s, efforts to bring
inflation and inflation expectations back to desirable levels after they have risen appreciably
involve costly and undesirable changes in resource utilization.11 As a result, the degree to
confirmed by Mark Hooker (2002) in his work documenting a break in the link between oil prices and inflation
in recent decades.
7
For example, Rudd and Whelan (2007) and Kiley (2007) review a number of models and empirical studies as
well as conduct their own empirical analyses; these two studies reach quite different conclusions on the merits
of alternative specifications.
8
For example, see the article by Chao Wei (2003) illustrating the effects of a rise in oil prices in a dynamic
equilibrium model.
9
Erceg, Henderson, and Levin (2000) discuss the importance of relative price adjustments in the presence of
sluggish nominal prices and wages in a general context; Mankiw and Reis (2003) present related results.
Bodenstein, Erceg, and Guerrieri (2007) apply this reasoning to oil price shocks.
10
See Taylor (1979).
11
Ball (1994) presents estimates of the costs of disinflation for a variety of countries, including the United States.
Kiley (2008) provides evidence on how survey measures of inflation expectations in the United States have
responded to economic developments and presents a model that attempts to explain the patterns in the data.
BIS Review 76/2008
which any deviations of inflation from long-run objectives are tolerated to allow the efficient
relative price adjustments that I have described needs to be tempered so as to ensure that
longer-term inflation expectations are not affected to a significant extent.
Global demand, trending commodity prices, and monetary policy
My remarks so far have concentrated on the factors guiding the monetary policy response to
a shock in the prices of commodities like oil that stems from a shifting balance of supply and
demand in the specific market for these commodities. Some might think that this focus
misses the point in the current context, for at least two reasons. First, it has been suggested
that the run-up in the prices of a broad range of commodity prices reflects, in part, global
excess demand rather than sector-specific forces. And second, some have suggested that
important commodity prices, like that of oil, may be on a more significant upward trend than
is currently embedded in futures prices.
It seems highly likely that, over the period since 2003, the rise in commodity prices has
reflected strong global economic growth as well as some sector-specific factors, such as
geopolitical tensions and other disruptions to the supply of oil.12 In this regard, I share the
views expressed by Chairman Bernanke at this conference two days ago in which he
discussed a range of factors that have likely influenced relative commodity prices.13
However, the fact that rising relative commodity prices have likely reflected many factors
does not, by itself, change the analytical framework that I used to frame policy deliberations.
As I highlighted at the beginning of my remarks, the most important drivers of inflation in the
model of inflation dynamics I use are relative price shocks, inflation expectations, and the
balance between aggregate demand and supply in the United States, as measured by some
notion of resource utilization. If a shift in global demand affects both commodity prices and
the demand for U.S. goods, the model I have in mind accounts for these influences on
inflation through relative price shocks and resource utilization. For example, the rise in the
price of oil this year has lowered consumption demand by pinching households' real incomes
and likely damped the growth in labor productivity by trimming energy input; both of these
factors have probably contributed to a lower equilibrium real wage, as I described earlier. If
the impact on demand from these factors was accompanied by stronger global demand that
boosted demand for U.S. goods generally, the forecasts of inflation would need to take this
into account. In any event, resource utilization has been slackening, judging from the rise in
the unemployment rate and the slow pace of economic growth in the United States, on
average, over the past six to nine months.
Some have suggested that the price of oil is on a more significant upward trend than
currently appreciated.14 Such an unanticipated shift in trend would not be embedded in the
anticipated rate of change in slowly adjusting nominal prices and wages, implying that an
adjustment period with distortions to relative prices would follow. Moreover, there would likely
Orphanides and Williams (2005) present a model in which perpetual learning leads to fluctuations in inflation
expectations at various horizons and provide examples of how alternative monetary policy settings can
influence the course of inflation expectations, thereby illustrating the importance of the interaction between
expectations formation and efficient monetary policy.
12
With regard to oil prices, Bodenstein, Erceg, and Guerrieri (2008) discuss the effects on the price of oil and the
U.S. economy from shocks to various factors in a theoretical model; Kilian (2007) provides an empirical
analysis. More generally, this area remains a fertile field for future research.
13
See Bernanke (2008).
14
One might question whether significant price trends can reasonably be anticipated for a storable commodity
like oil. The price of such a commodity should reflect expected demand and "anticipated" increases should be
limited to approximately the cost of storage, including the nominal interest rate. Still, the following discussion
would also apply to a shift in the trend in any important subset of consumer prices.
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be upward pressure on overall inflation during this period, reflecting the slow response of the
rate of change in some nominal prices to the new trend in the price of oil. This tendency for
higher overall inflation could risk a rise in inflation expectations.
An appropriate monetary policy response would share many of the characteristics I
discussed earlier. In particular, bringing overall inflation immediately back to the low rate
consistent with price stability could be associated with a much higher rate of unemployment
for a short time. It may be efficient to allow some adjustment period in which both overall
inflation exceeds its desired low level and the unemployment rate is higher than its long-run
sustainable level; as before, setting policy in a manner that balances the undesirable effects
of a shock to the system on both inflation and employment will tend to be more efficient than
setting policy so as to deliver more extreme outcomes in either inflation or unemployment.15
However, two additional considerations are likely important when considering a shift in trend.
First, developments in inflation expectations following a significant shift in the relative price
trend of a commodity like oil should be monitored carefully, as our understanding of changes
in long-run inflation expectations is limited and shifts in trends are infrequent, potentially
implying a greater chance of confusion between relative price trends and overall inflation.
Second, it is very important to remember that the costs of inflation in excess of the low rate of
measured inflation consistent with price stability over any extended period are significant and
reflect a broad range of factors. As I emphasized earlier, economic research into the many
costs of inflation has suggested that these costs are associated with the rate of change in a
broad set of prices. As a result, a trend in any individual relative price should not, in itself,
lead to a change in the desirable rate of measured inflation over the long run.
Summary
To reiterate, the Phillips curve framework is one important input to my outlook for inflation
and provides a framework in which I can analyze the nature of efficient policy choices. In the
case of a shock to the relative price of oil or other commodities, this framework suggests that
policymakers should ensure that their actions balance the deleterious economic effects of
such a shock in the short run on both unemployment and inflation.
Of course, the framework helps to define the short-run goals for policy, but it doesn't tell you
what path for interest rates will accomplish these objectives. That's what we wrestle with at
the FOMC and is perhaps a subject for a future Federal Reserve Bank of Boston conference.
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