Ben S Bernanke: Outstanding issues in the analysis of inflation
Speech of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Boston's 52nd Annual Economic
Conference, Chatham, Massachusetts, 9 June 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
Good evening. I am pleased to be able to participate in the Federal Reserve Bank of
Boston's 52nd annual economic conference, on the topic of inflation and the Phillips curve.
Forecasting and controlling inflation are, of course, central to the process of making
monetary policy. In this respect, policymakers are fortunate to be able to build on an
intellectual foundation provided by extensive research and practical experience.
Nonetheless, much remains to be learned about both inflation forecasting and inflation
control. In the spirit of this conference, my remarks this evening will highlight some key areas
where additional research could help to provide a still-firmer foundation for monetary
policymaking.
Before turning to those issues, however, I would like to provide a brief update on the outlook
for the economy and policy, beginning with the prospects for growth. Despite the unwelcome
rise in the unemployment rate that was reported last week, the recent incoming data, taken
as a whole, have affected the outlook for economic activity and employment only modestly.
Indeed, although activity during the current quarter is likely to be weak, the risk that the
economy has entered a substantial downturn appears to have diminished over the past
month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a
gradual ebbing of the drag from residential construction, further progress in the repair of
financial and credit markets, and still-solid demand from abroad should provide some offset
to the headwinds that still face the economy. However, the ongoing contraction in the
housing market and continuing increases in energy prices suggest that growth risks remain
to the downside.
One of the most effective means by which the Federal Reserve can help to restore moderate
growth over time and to reduce the associated downside risks is by supporting the return of
financial markets to more-normal functioning. We have taken a number of actions to promote
financial stability and remain strongly committed to that objective.
Inflation has remained high, largely reflecting sharp increases in the prices of globally traded
commodities. Thus far, the pass-through of high raw materials costs to the prices of most
other products and to domestic labor costs has been limited, in part because of softening
domestic demand. However, the continuation of this pattern is not guaranteed and future
developments in this regard will bear close attention. Moreover, the latest round of increases
in energy prices has added to the upside risks to inflation and inflation expectations. The
Federal Open Market Committee will strongly resist an erosion of longer-term inflation
expectations, as an unanchoring of those expectations would be destabilizing for growth as
well as for inflation.
Turning now to the principal topic of my remarks, I will briefly touch on four topics of
particular interest for policymakers: commodity prices and inflation, the role of labor costs in
the price-setting process, issues arising from the necessity of making policy in real time, and
the determinants and effects of changes in inflation expectations. Economists within the
Federal Reserve System and at other central banks have made and will continue to make
important contributions in these areas. However, researchers in academia and elsewhere
have long been essential partners in building the intellectual foundations for the conduct of
monetary policy. One of my objectives today is to encourage the continuation of this fruitful
collaboration.
Commodity prices and inflation
Rapidly rising prices for globally traded commodities have been the major source of the
relatively high rates of inflation we have experienced in recent years, underscoring the
importance for policy of both forecasting commodity price changes and understanding the
factors that drive those changes.
Policymakers and other analysts have often relied on quotes from commodity futures
markets to derive forecasts of the prices of key commodities. However, as you know, futures
markets quotes have underpredicted commodity price increases in recent years, leading to
corresponding underpredictions of overall inflation. The poor recent record of commodity
futures markets in forecasting the course of prices raises the question of whether
policymakers should continue to use this source of information and, if so, how.
Despite this recent record, I do not think it is reasonable, when forecasting commodity prices,
to ignore the substantial amounts of information about supply and demand conditions that
are aggregated by futures markets. Indeed, the use of some simple alternatives - such as
extrapolating recent commodity price trends - would require us to assume that investors in
commodity futures can expect to earn supernormal risk-adjusted returns, inconsistent with
principles of financial arbitrage. However, it does seem reasonable - and consistent with the
wide distributions of commodity price expectations implied by options prices - to treat the
forecasts of commodity prices obtained from futures markets, and consequently the forecasts
of aggregate price inflation, as highly uncertain.
These considerations raise several questions for researchers: First, is it possible to improve
our forecasts of commodity prices, using information from futures markets but possibly other
information as well? For example, the markets for longer-dated futures contracts are often
quite illiquid, suggesting that the associated futures prices may not effectively aggregate all
available information. Second, what are the implications for the conduct of monetary policy of
the high degree of uncertainty that attends forecasts of commodity prices? Although
theoretical analyses often focus on the case in which policymakers care only about expected
economic outcomes and not the uncertainty surrounding those outcomes, in practice
policymakers are concerned about the risks to their projections as well as the projections
themselves. How should those concerns affect the setting of policy in this context?
Whatever the forecasting value of futures market quotes, these and other financial market
prices provide limited information about the structural relationships between commodity
prices and their determinants. Absent a specification of those structural relationships, one
cannot analyze the effects of alternative monetary policies or the implications of other shocks
to the economy.
Empirical work on inflation, including much of the classic work on Phillips curves, has
generally treated changes in commodity prices as an exogenous influence on the inflation
process, driven by market-specific factors such as weather conditions or geopolitical
developments. By contrast, some analysts emphasize the endogeneity of commodity prices
to broad macroeconomic and monetary developments such as expected growth, expected
inflation, interest rates, and currency movements. Of course, in reality, commodity prices are
influenced by both market-specific and aggregate factors. Market-specific influences are
evident in the significant differences in price behavior across individual commodities, which
often can be traced to idiosyncratic supply and demand factors. Aggregate influences are
suggested by the fact that the prices of several major classes of commodities, including
energy, metals, and grains, have all shown broad-based gains in recent years. In particular, it
seems clear that commodity prices have been importantly influenced by secular global trends
affecting the conditions of demand and supply for raw materials. We have seen rapid growth
in the worldwide demand for raw materials, which in turn is largely the result of sustained
global growth - particularly resources-intensive growth in emerging market economies.1 And
factors including inadequate investment, long lags in the development of new capacity, and
underlying resource constraints have caused the supplies of a number of important
commodity classes, including energy and metals, to lag global demand. These problems
have been exacerbated to some extent by a systematic underprediction of demand and
overprediction of productive capacity for a number of key commodities, notably oil. Further
analysis of the range of aggregate and idiosyncratic determinants of commodity prices would
be fruitful.
I have only mentioned a few of the issues raised by commodity price behavior for inflation
and monetary policy. Here are a few other questions that researchers could usefully address:
First, how should monetary policy deal with increases in commodity prices that are not only
large but potentially persistent? Second, does the link between global growth and commodity
prices imply a role for global slack, along with domestic slack, in the Phillips curve? Finally,
what information about the broader economy is contained in commodity prices? For
example, what signal should we take from recent changes in commodity prices about the
strength of global demand or about expectations of future growth and inflation?
The role of labor costs in price setting
Basic microeconomics tells us that marginal cost should play a central role in firms' pricing
decisions. And, notwithstanding the effects of changes in commodity prices on the cost of
production, for the economy as a whole, by far the most important cost is the cost of labor.
Over the past decade, formal work in the modeling of inflation has treated marginal cost,
particularly the marginal cost of labor, as central to the determination of inflation.2 However,
the empirical evidence for this linkage is less definitive than we would like.3 This mixed
evidence is one reason that much Phillips curve analysis has centered on price-price
equations with no explicit role for wages.4
Problems in the measurement of labor costs may help explain the absence of a clearer
empirical relationship between labor costs and prices. Compensation per hour in the nonfarm
business sector, a commonly used measure of labor cost, displays substantial volatility from
quarter to quarter and year to year, is often revised significantly, and includes compensation
that is largely unrelated to marginal costs - for example, exercises (as opposed to grants) of
stock options. These and other problems carry through to the published estimates of labor's
share in the nonfarm business sector - the proxy for real marginal cost that is typically used
in empirical work. A second commonly used measure of aggregate hourly labor
compensation, the employment cost index, has its own set of drawbacks as a measure of
marginal cost. Indeed, these two compensation measures not infrequently generate
conflicting signals of trends in labor costs and thus differing implications for inflation.
The interpretation of changes in labor productivity also affects the measurement of marginal
cost. As economists have recognized for half a century, labor productivity tends to be
procyclical, in contrast to the theoretical prediction that movements along a stable,
conventional production function should generate countercyclical productivity behavior. Many
explanations for procyclical productivity have been advanced, ranging from labor hoarding in
downturns to procyclical technological progress. A better understanding of the observed
procyclicality of productivity would help us to interpret cyclical movements in unit labor costs
and to better measure marginal cost.
The relationship between marginal cost, properly measured, and prices also depends on the
markups that firms can impose. One important open question is the degree to which variation
over time in average markups may be obscuring the empirical link between prices and labor
costs. Considerable work has also been done on the role of time-varying markups in the
inflation process, but a consensus on the role of changing markups on the inflation process
remains elusive.5 More research in this area, particularly with an empirical orientation, would
be welcome.
Real-time policymaking
The measurement issues I just raised point to another important concern of policymakers,
namely, the necessity of making decisions in "real time," under conditions of great
uncertainty - including uncertainty about the underlying state of the economy - and without
the benefit of hindsight.
In the context of Phillips curve analysis, a number of researchers have highlighted the
difficulty of assessing the output gap - the difference between actual and potential output -
in real time.6 An inability to measure the output gap in real time obviously limits the
usefulness of the concept in practical policymaking. On the other hand, to argue that output
gaps are very difficult to measure in real time is not the same as arguing that economic slack
does not influence inflation; indeed, the bulk of the evidence suggests that there is a
relationship, albeit one that may be less pronounced than in the past.7 These observations
suggest two useful directions for research: First, more obviously, there is scope to continue
the search for measures or indicators of output gaps that provide useful information in real
time. Second, we need to continue to think through the decision procedures that
policymakers should use under conditions of substantial uncertainty about the state of the
economy and underlying economic relationships. For example, even if the output gap is
poorly measured, by taking appropriate account of measurement uncertainties and
combining information about the output gap with information from other sources, we may be
able to achieve better policy outcomes than would be possible if we simply ignored noisy
output gap measures. Of course, similar considerations apply to other types of real-time
economic information.
Inflation itself can pose real-time measurement challenges. We have multiple measures of
inflation, each of which reflects different coverage, methods of construction, and seasonality,
and each of which is subject to statistical noise arising from sampling, imputation of certain
prices, and temporary or special factors affecting certain markets. From these measures and
other information, policymakers attempt to infer the "true" underlying rate of inflation. In other
words, policymakers must read the incoming data in real time to judge which changes in
inflation are likely to be transitory and which may prove more persistent. Getting this
distinction right has first-order implications for monetary policy: Because monetary policy
works with a lag, policy should be calibrated based on forecasts of medium-term inflation,
which may differ from the current inflation rate. The need to distinguish changes in the
inflation trend from temporary movements around that trend has motivated attention to
various measures of "core," or underlying, inflation, including measures that exclude certain
prices (such as those of food and energy), "trimmed mean" measures, and others, but other
approaches are certainly worth consideration.8 Further work on the problem of filtering the
incoming data so as to obtain better measures of the underlying inflation trend could be of
great value to policymakers.
The necessity of making policy in real time highlights the importance of maintaining and
improving the economic data infrastructure and, in particular, working to make economic data
timelier and more accurate. I noted earlier the problems in interpreting existing measures of
labor compensation. Significant scope exists to improve the quality of price data as well - for
example, by using the wealth of information available from checkout scanners or finding
better ways to adjust for quality change. I encourage researchers to become more familiar
with the strengths and shortcomings of the data that they routinely use. Besides leading to
better analysis, attention to data quality issues by researchers often leads to better data in
the longer term, both because of the insights generated by research and because
researchers are important and influential clients of data collection agencies.
Inflation expectations
Finally, I will say a few words on inflation expectations, which most economists see as
central to inflation dynamics. But there is much we do not understand about inflation
expectations, their determination, and their implications. I will divide my list of questions into
three categories.
First, we need to understand better the factors that determine the public's inflation
expectations. As I discussed in some detail in a talk at the National Bureau of Economic
Research last summer, much evidence suggests that expectations have become better
anchored than they were a few decades ago, but that they nonetheless remain imperfectly
anchored.9 It would be quite useful for policymakers to know more about how inflation
expectations are influenced by monetary policy actions, monetary policy communication, and
other economic developments such as oil price shocks.
The growing literature on learning in macroeconomic models appears to be a useful vehicle
to address many of these issues.10 In a traditional model with rational expectations, a fixed
economic structure, and stable policy objectives, there is no role for learning by the public. In
such a model, there is generally a unique long-run equilibrium inflation rate which is fully
anticipated; in particular, the public makes no inferences based on central bankers' words or
deeds. But in fact, the public has only incomplete information about both the economy and
policymakers' objectives, which themselves may change over time. Allowing for the
possibility of learning by the public is more realistic and tends to generate more reasonable
conclusions about how inflation expectations change and, in particular, about how they can
be influenced by monetary policy actions and communications.
The second category of questions involves the channels through which inflation expectations
affect actual inflation. Is the primary linkage from inflation expectations to wage bargains, or
are other channels important? One somewhat puzzling finding comes from a survey of
business pricing decisions conducted by Blinder, Canetti, Lebow, and Rudd, in which only a
small share of respondents claimed that expected aggregate inflation affected their pricing at
all.11 How do we reconcile this result with our strong presumption that expectations are of
central importance for explaining inflation? Perhaps expectations affect actual inflation
through some channel that is relatively indirect. The growing literature on disaggregated
price setting may be able to shed some light on this question.12
Finally, a large set of questions revolve around how the central bank can best monitor the
public's inflation expectations. Many measures of expected inflation exist, including
expectations taken from surveys of households, forecasts by professional economists, and
information extracted from markets for inflation-indexed securities. Unfortunately, only very
limited information is available on expectations of price-setters themselves, namely
businesses. Which of these agents' expectations are most important for inflation dynamics,
and how can central bankers best extract the relevant information from the various available
measures?
Conclusion
This evening I have touched on only a few of the questions that confront policymakers as we
deal with the challenges we face. The contributions of economic researchers in helping us to
address these and other important questions have been and will continue to be invaluable. I
will conclude by offering my best wishes for an interesting and productive conference.
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Asking
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