Donald L Kohn: Inflation modelling - a policymaker's perspective
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal
Reserve System, at the Quantitative Evidence on Price Determination Conference,
Washington DC, 29 September 2005.
* * *
An occasion like this one is a natural opportunity to reflect on how policymakers'
understanding of the inflation process has progressed over time.1 Clearly we have come a
long way since the early 1970s. Most important, we have absorbed the central lesson of
Milton Friedman's 1968 address to the American Economic Association--that any tradeoff
between inflation and unemployment is only temporary because of the dynamic nature of
expectations. We have also taken on board the practical application of this lesson that
monetary policy must be vigilant about anchoring inflation expectations. Operationally,
maintaining price stability requires abiding by the Taylor principle of raising nominal interest
rates more than one for one in response to movements in inflation, especially those
movements perceived as persistent. It also requires that policy tighten or ease systematically
to bring aggregate demand in line with the economy's productive potential, not only because
output stabilization is a policy objective in its own right but also because such actions help to
head off undesirable changes in inflation down the road.
These basic precepts, embraced by central bankers everywhere, have almost certainly
contributed to the improved performance of inflation over the past decade or two, and this
better price performance probably has helped to damp business cycles. Of course,
economists and policymakers still have a great deal to learn about the interactions of
monetary policy, the real economy, and inflation. But as the conference papers illustrate, we
are making progress.
Still, when it comes to inflation modeling and policymaking, as my grade school report cards
used to say: There is room for improvement. Specifically, I wonder whether current inflation
research adequately addresses the questions that bedevil me as a policymaker. Tonight I
cannot resist the opportunity presented by having access to a captive group of researchers
to share these concerns with you, with the intention of providing some constructive
suggestions for future work.
What properties am I looking for in a model of inflation and the economy overall? First, the
model should provide a coherent analytical framework that the policymaker can use to
interpret incoming data and to choose a proper policy response. Second, the model should
provide an accurate empirical description of the economy as it relates to both forecasting and
the influence of policy on the outlook. My experience on the Federal Open Market Committee
(FOMC) as a consumer of model-based forecasts and analysis suggests that work remains
to be done on both fronts--and, in particular, on meeting both objectives with the same
model.
As regards the first property, the conceptual--albeit informal--framework that many
policymakers like to use is largely "bottom up" and features costs and expectations. It starts
with wages and the prices of other inputs into production, and after taking into account
productivity, it sees prices set as a markup over unit costs. Wage determination plays a key
role in this framework and is influenced by such factors as inflation expectations, productivity,
and labor market slack; the markup, too, is important because it varies over time depending
on changes in the competitive environment, expected future costs, and other factors.
At first glance, the empirical structural models currently favored in academic research and
discussed at this conference--such as the New Keynesian Phillips curve--appear to conform
to the informal policymaker model: Expectations formation is dealt with formally, and price
inflation, at least in some empirical representations, is directly tied to measures of unit labor
costs. On closer inspection, however, one sees that the specifications of these models
typically ignore important factors bearing on the inflation outlook.
One category of neglected factors is price shocks--changes in the levels of key inputs, such
as energy or imports. Policymakers spend a great deal of time discussing the circumstances
under which such shocks can lead to persistent changes in the rate of inflation. Yet, despite
their historical importance for aggregate inflation, energy prices, for example, are controlled
for in only one of the structural models discussed at this conference. And this importance is
not necessarily a concern of the past: Prices for oil and natural gas have soared since 2003,
directly boosting the energy component of the consumer price index as well as raising the
production costs, and ultimately to at least some degree the prices, of non-energy goods and
services. As a policymaker, I can assure you that any model of inflation that did not take
account of these effects, and how they might or might not affect ongoing rates of inflation,
would have been of little practical use to the FOMC over the past few years.
Reduced-form regressions suggest that the response of core inflation to energy prices has
diminished over the past twenty years. Does this smaller response reflect a change in the
expectations formation process that has come about because the public perceives that
inflation will remain low, perhaps because the monetary authority is now seen to be more
vigilant in reacting to price pressures? Or does it reflect a reduction, from the late 1970s until
a couple of years ago, in the persistence of energy price movements that has prompted firms
to be less worried about passing temporary cost increases onto customers? Determining
which of these explanations is most important is a critical issue for monetary policy right now,
when futures markets indicate that people expect the current elevated price of energy to
persist.
But economists are not well positioned to provide much evidence on this issue, given the
relative paucity of empirical work on expectations formation. Certainly the standard approach
used to estimate structural models is not that helpful because it simply assumes an
answer-rational expectations, typically accompanied by full central bank credibility. But how well does
this assumption match reality? True, financial market participants do seem to respond to
incoming economic data in a generally forward-looking and logical manner, but we also
observe asset price levels, volatility, and implied risk premiums that are sometimes difficult to
understand. And I doubt that any central bank has achieved perfect credibility in the markets.
Moreover, it is not obvious that investors' expectations always line up with those of
households and firms, the ones that should matter for wage and price setting. We really
know very little about the precise manner in which these agents form their beliefs about the
future, in part because of a lack of comprehensive data on expectations. Nonetheless,
economists are certainly grappling with this issue, as evidenced by the growing interest of
late in models that incorporate rational inattention, sticky information, learning, and imperfect
credibility. Behavioral economics, with its focus on how people perceive and act on
information in making decisions, may also provide some insights into the modeling of
expectations.
If plausible departures from rational expectations and full credibility are empirically verified,
then our structural models need to take that into account. A new set of questions would then
be on the table in policy analysis. Among other questions that could be addressed would be
how policy actions (as opposed to inflation outcomes) influence expectations and how
sensitive Federal Reserve credibility is to short-run departures from low inflation. Such
knowledge would be extremely useful in current circumstances in gauging the scope for
monetary policy to offset the short-run output effects of higher energy prices without
triggering adverse longer-run inflation consequences.
Another area needing further attention is wage setting. My impression, reinforced by the
papers at this conference, is that many of the newer empirical structural models of price
inflation posit a central role for real marginal cost but seem to have little to say about its
determination or that of its main component, labor compensation. This neglect may reflect
the difficulty of specifying the aggregate dynamics of an atomistic labor market characterized
by pronounced heterogeneity, significant informational imperfections, and important
adjustment costs. By comparison, these complications seem less severe in product markets,
which for the most part are more transparent and easier to analyze. Moreover, as I will
discuss in a minute, empirical work on wage determination may be especially hindered by
issues of data quality.
Let me give an example of why I think it is important to have a firm grasp of how wages are
set. Many economists, both inside and outside the Federal Reserve, think that the
acceleration in labor productivity in the mid-1990s subsequently helped to restrain the rate of
price inflation. This conclusion requires that the adjustment of nominal wages to the higher
trend in productivity was slow, an outcome that put downward pressure on unit labor costs
and, hence, on prices. Its consistency with the data notwithstanding, I would be more
comfortable with this hypothesis if it were supported by a structural model of wage
determination that was firmly grounded in theory and microevidence.
As noted earlier, the design of sound structural models is only a start. As a policymaker, I
need those models to provide accurate forecasts and empirically well-grounded policy
analysis. The analysis contained in the papers by Rudd and Whelen, Kiley, and Laforte are
valuable first steps in comparing the empirical properties of alternative structural and
reduced-form models.
Nonstructural specifications, despite their shortcomings with regard to the desirable model
properties I noted earlier, do have an important role to play in policymaking--in particular,
forecasting. Structural models do not as yet fully encompass the information used by
reduced-form specifications, and the historical relationships summarized in these latter
models have often proven to be more useful guides to future inflation developments. Such
models often include energy- and import-price terms along with measures of slack and
expectations. They inform the staff's judgmental inflation forecast as well as my own thinking
about the outlook.
Data measurement issues add to the challenge of developing better empirical models for
policy work. One important example concerns hourly labor compensation. The measure
reported in the national accounts is often revised significantly, displays substantial volatility
from quarter to quarter, and has components that may not coincide with the labor costs
relevant to business pricing decisions. These deficiencies, among others, also affect
published estimates of labor's share in the nonfarm business sector--the usual measure of
real marginal cost used in empirical work. Other measures of labor compensation, such as
the employment cost index, have their own particular deficiencies and can yield conflicting
signals of trends in labor costs. An unpleasant implication of these various data problems is
that they may make difficult the development of structural models incorporating wage
behavior that are reliable enough for policy analysis, despite their attractiveness to
policymakers like me.
Of course, measurement issues do not afflict only models that exploit data on labor
compensation. Many inflation models in use, both structural and reduced-form, include some
measure of resource utilization as a determinant of price inflation, such as the gap between
the unemployment rate and the non-accelerating inflation rate of unemployment (NAIRU).
And as we know, the latter cannot be directly observed. Although economists have made
some progress in estimating potential output, policymakers should be cautious about
responding aggressively to estimated movements in economic slack.
Paradoxically, the ability to confirm our estimates of output relative to potential in a timely
way may have been diminished by the success of the Federal Reserve and other central
banks in achieving low and stable inflation. Although controversial, some evidence from
reduced-form price equations suggests that inflation has become less sensitive to economic
slack in recent years, possibly as a consequence of more firmly anchored inflation
expectations. Consistent with this evidence, the Board staff's rule-of-thumb estimate of the
sacrifice ratio rose from around 2 or 3 in the mid-1980s to around 4 currently.2 Imbalances
between demand and potential supply would thus now be slow to show through convincingly
to inflation, but when they do, they may be costly to correct.
The various specification and empirical issues that I have raised tonight are major
challenges, and based on our experience using the FRB/US model here at the Board, they
may prove quite difficult to overcome. FRB/US has many of the desirable attributes
mentioned earlier. In particular, its wage and price equations are variants of the New
Keynesian Phillips curve, with core specifications that are derived from cost minimization and
equations that are estimated assuming rational expectations. However, in incorporating the
effects of such factors as energy costs, import prices, and productivity into the model's
wageprice block, the staff found it necessary to sacrifice some theoretical niceties in order to get
close to the predictive accuracy provided by reduced-form models. Perhaps future
researchers will be able to resolve this tension in some clever way, but some tradeoff
between purity of design and forecasting accuracy probably will always be unavoidable. In
addition, the staff's experience with FRB/US illustrates some of the problems inherent in
using real-time wage data. Although the policy analyses generated using the model have
been quite useful from my perspective, and the model has compiled a reasonable forecasting
record overall, the accuracy of its price inflation forecasts has suffered from their sensitivity to
current readings on labor's share.
These remarks have presented a long list of "helpful" suggestions for future research. You
might ask: Does successful monetary policymaking really require all this additional
knowledge? Do not central banks already have what they need to do a good job? If
policymakers continue to recognize the critical role of long-term price stability, keep a close
eye on inflation expectations, and adhere to the Taylor principle, would not things be OK, as
they have been for much of the past twenty years?
This view strikes me as too complacent. Even if it is true that things tend to turn out OK on
average under the present state of knowledge, macroeconomic performance could be better
yet if policymakers were able to take advantage of a fuller understanding of the dynamics of
the economy. And we would do well to be cautious about attributing the good
macroeconomic performance entirely to good monetary policy. Decomposing the sources of
the Great Moderation is a difficult business, and a number of researchers interpret the
evidence as suggesting that monetary policy was not the most important factor. Luck as well
as structural changes in the economy may have had a lot to do with the current low level and
apparent stability of U.S. inflation. If so, and if our luck turns and we experience a series of
adverse shocks, our ability to formulate policies that deliver sound performance may depend
upon a much better understanding of the inflation process and of expectations formation.