Frederic S Mishkin: Inflation dynamics
Remarks by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal Reserve
System, at the Annual Macro Conference, Federal Reserve Bank of San Francisco, San Francisco,
California, 23 March 2007.
* * *
Under its dual mandate, the Federal Reserve seeks to promote both price stability and maximum
sustainable employment.1 For this reason, we at the Federal Reserve are acutely interested in the
inflation process, both to better understand the past and - given the inherent lags with which monetary
policy affects the economy - to try to forecast the future. We economists have made some important
strides in our understanding of inflation dynamics in recent years. To be sure, substantial gaps in our
knowledge remain, and forecasting is still a famously imprecise task, but our increased understanding
offers the hope that central banks will be able to continue and perhaps even improve upon their
successful performance of recent years.
Today, I will outline what I see as the key stylized facts that research has in recent years uncovered
about changes in the dynamics of inflation and will present my view of how to interpret these findings.
The interpretation has important implications for how we should think about the conduct of monetary
policy and what we think might happen to inflation over the next couple of years. I will address these
two issues in the final part of the talk. Before I continue, however, I should stress that the views I will
express here are my own and are not necessarily those of my colleagues on the Federal Open Market
Committee (FOMC).
The empirical evidence on changes in inflation dynamics
To see what research has discovered about the evolution of inflation dynamics in recent years, let's
explore the following questions: (1) What is the available evidence on changes in inflation persistence
in recent years? (2) What is the available evidence on changes in the slope of the Phillips curve? (3)
What role do other variables play in the inflation process?
Inflation persistence
To answer the first question, we need to measure how long the effects of a shock to inflation will last.
Specifically, we need to know whether inflation tends to revert quickly to its initial level, or whether the
effects of the shock persist - that is, lead to a changed level of inflation for an extended period. The
most obvious way of measuring inflation persistence is to regress inflation on several of its own lags
and then calculate the sum of the coefficients on lagged inflation. If the sum of the coefficients is close
to 1.0, then shocks to inflation have long-lived effects on inflation. In other words, inflation behaves like
a random walk, so that when inflation goes up, it stays up. If the sum of the coefficients drops well
below 1.0, then a shock to inflation has only a temporary effect on inflation, and inflation soon reverts
back to its trend level.
The evidence from these so-called autoregressions with U.S. data suggests that inflation may have
grown less persistent over time. In particular, when autoregressions are run using rolling samples with
a fixed width of, say, twelve years, the sum of the lagged coefficients often falls noticeably below unity
as the sample advances to include the most recent data. Figure 1 illustrates this tendency, with the
core personal consumption expenditures (PCE) price index as the measure of inflation. As you can
see, the coefficient sum has declined to about 0.6 or so since the late 1990s, although the dotted lines
indicate that the confidence interval for this estimate is wide and still includes 1.0. This result appears
robust to the addition of other explanatory variables to the regression, although making such a
modification does tend to reduce the extent of the estimated decline.2 Finally, it's worth noting that this
is not just a U.S. phenomenon, as some studies have found similar results for a number of other
countries.3
(I might proudly note in passing that the staff of the Federal Reserve System is responsible for much
of this research. To avoid boring you, I will refrain from providing references to this research, but the
version on this speech on the Board's web site will include this information and will provide a more
nuanced discussion of these results.)
Recent work by Jim Stock and Mark Watson (2007) provides an alternative and, to me, a quite intuitive
way of thinking about inflation persistence. They estimate a model that decomposes inflation into two
components. The first component, which can be thought of as the underlying trend, follows a random
walk, so that shocks to this component persist indefinitely and thus affect the trend inflation rate going
forward. The second component is a serially uncorrelated shock, meaning that such shocks are
temporary and lead to only transitory fluctuations around the trend. Stock and Watson then allow the
volatility of these two kinds of shocks, trend and temporary, to vary over time.
Stock and Watson find that the importance of the trend shocks relative to that of the temporary shocks
started to rise at the end of the 1960s in the United States, peaked in the mid-1970s, stayed elevated
over the next ten years, and then declined to a historical low (upper panel of figure 2). When the
relative importance of the trend shocks became high, as it did in the 1970s and early 1980s, inflation
became highly persistent. Under such conditions, if inflation went up, the trend component typically
rose in tandem so that inflation stayed up. In contrast, when the temporary shocks were relatively
more important, as was true before the 1970s and after the mid-1980s, a change in inflation tended to
reflect a change in the temporary component, not the trend. As a result, fluctuations in inflation tended
to fade away, implying that inflation persistence was much lower. In the context of the Stock-Watson
model, then, when inflation rose to double-digit levels during the "Great Inflation" period of the 1970s
and early 1980s, persistence became very high because the trend rate of inflation moved around a lot
- that is, trend inflation became unanchored.
Although the importance of the trend component has fallen markedly since the 1970s, the estimates
produced by Stock and Watson suggest that it is still large enough to be economically meaningful. The
bottom panel of figure 2 illustrates this point; as you can see, the estimated trend (the solid line) has
drifted up a bit since the mid-1990s. Of course, such estimates are inevitably imprecise to some
degree. For example, Cecchetti et al (2007) employ a slightly modified version of the Stock-Watson
procedure in a recent paper and find that inflation persistence has fallen so low that their estimated
trend for gross domestic product (GDP) price inflation has been almost perfectly flat at about 2.2
percent over the past few years. In contrast, Cogley and Sargent (2005), using a different modification
of the procedure, obtain results more in line with the original Stock and Watson paper. Finally,
followup work by staff members at the Federal Reserve Board suggests that the degree of persistence
found with these techniques varies across different measures of inflation. Thus, the empirical evidence
on this question can vary. Nonetheless, I think it fair to say that inflation has become less persistent
over the past two decades but that the underlying trend may not yet be perfectly stable.
When Cecchetti and his co-authors apply this type of analysis to other countries, the results are
remarkably similar. In particular, in Canada, Italy, and the United Kingdom, the importance of the trend
shocks began to rise in the late 1960s and early 1970s and then declined only in the mid-1980s.
France followed a similar pattern, although there the rise began a bit earlier, in 1963. In short, all these
countries experienced a similar "Great Inflation," when trend inflation became unanchored. Germany
and Japan had shorter periods of high persistence of inflation, with persistence beginning to decline
around 1969 in Germany and around 1979 in Japan. Cecchetti and his co-authors conclude that the
rise and subsequent decline of inflation persistence has thus been a worldwide phenomenon.
Slope of the Phillips Curve
In traditional Phillips-curve equations, inflation depends on past values of inflation, an unemployment
gap (the difference between the unemployment rate and an estimate of its natural rate), and variables
such as the relative price of energy and import prices. When researchers estimate these equations,
they typically find that the coefficient on the unemployment gap has declined (in absolute value) since
the 1980s, often by a marked amount.4 In other words, the evidence suggests that the Phillips curve
has flattened.
The finding that inflation is less responsive to the unemployment gap, if taken at face value, suggests
that fluctuations in resource utilization will have smaller implications for inflation than used to be the
case. From the point of view of policymakers, this development is a two-edged sword: On the plus
side, it implies that an overheating economy will tend to generate a smaller increase in inflation. On
the negative side, however, a flatter Phillips curve also implies that a given increase in inflation will be
more costly to wring out of the system. We can quantify this latter consideration using the so-called
sacrifice ratio - the number of years that unemployment has to be 1.0 percentage point greater than
its natural rate to reduce the inflation rate 1.0 percentage point. Averaging estimates obtained from a
comprehensive battery of equation specifications suggests that the sacrifice ratio may be 40 percent
larger - that is, it may be 40 percent more costly to reduce inflation than it was two decades ago. Is
this really bad news? I will return to this question later.
Role of other variables in the inflation process
Empirical evidence suggests that inflation has also become less responsive to other shocks. The two
oil price shocks in the 1970s were associated with large jumps in core inflation, whereas recent surges
in energy prices have not had a similar effect. This reduced sensitivity manifests itself in traditional
Phillips-curve models as a substantial decline in the estimated coefficient on the energy price term in
these equations. Because this term equals the change in relative energy prices multiplied by the share
of energy in aggregate output, energy price effects on inflation appear to have fallen by more than can
be accounted for by the greater energy efficiency of the economy.5
In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once
we take the rising share of imports into account, the influence of import prices on core inflation in the
United States has not changed much in the context of reduced-form forecasting models.6 At the same
time, the influence of exchange rate movements on import prices - the so-called pass-through effect -
may have fallen substantially, at least according to some studies.7 If so, then the influence of
exchange rate fluctuations on domestic inflation may now be less than it once was, when one controls
for changes in the volume of our foreign trade.
What interpretation can we give to changes in inflation dynamics?
In interpreting these stylized facts about changes in inflation dynamics, we must first recognize that all
reduced-form
of them are based on relationships, and thus they are about correlations and not
necessarily about true structural relationships. Because the explanatory variables in inflation
4
Studies that present evidence of a marked decline in the sensitivity of U.S. inflation to unemployment and other measures of
resource utilization include Roberts (2006) and Williams (2006). Unpublished work by staff at the Federal Reserve Board
indicates that this result generally holds across a variety of regression specifications, estimation methods, and data
definitions. Other studies find similar declines in many foreign industrial economies; see, among others, Borio and Filardo
(2006) and Ihrig and others (forthcoming). However, the empirical evidence on this question is such that the exact
magnitude, timing, and statistical significance of these changes remain a subject of debate.
5
Hooker (2002) finds that oil price movements during the 1980s and 1990s had little or no effect on core inflation, in contrast
to a substantial influence in previous decades. Recent empirical work carried out at the Federal Reserve Board confirms
Hooker's findings using data through 2006; however, some of this work also hints that the surge in energy prices since 2004
may have had a larger influence on core inflation.
6
Interestingly, Ihrig and others (forthcoming) find that the sensitivity of inflation to movements in import prices has fallen in
several foreign industrial economies.
7
For evidence on U.S. exchange rate pass-through effects, see Marazzi and others (2005). Hellerstein, Daly, and Marsh
(2006) also find that pass-through has declined in the United States, although by a considerably smaller amount. Empirical
results for other developed countries are reported in Sekine (2006).
BIS Review 29/2007
regressions are themselves influenced by changes in economic conditions, changes in the underlying
monetary policy regime are likely to be a source of changes in reduced-form inflation dynamics. This
problem is especially acute for structural relationships involving expectations or other factors that are
not directly observable and so cannot be included in reduced-form regressions. In such cases, we
cannot use the reduced-form equations to disentangle the effects of such unobserved factors - which
themselves may be driven by changes in monetary policy - from that of other influences.
The most important development in monetary economics that I have witnessed over my now-long
career has been the recognition that expectations are central to our understanding of the behavior of
the aggregate economy. Theory tells us that inflation expectations must be a key driving force behind
inflation. This dependence has long been implicit in traditional Phillips-curve analysis, but expectations
- now in explicit form - are also a central feature of the increasingly popular New Keynesian Phillips
curves, in which current-period inflation is a function of expectations of next period's inflation and
resource utilization. Therefore, a natural first place to look for explanations of changing inflation
dynamics is a possible change in the expectations-formation process.
The first stylized fact discussed earlier is that inflation persistence, which rose in the 1970s during the
Great Inflation, has since declined to a much lower level. An intuitive way of thinking about this rise
and fall in inflation persistence is that it resulted from an un-anchoring of trend inflation during the
period of the Great Inflation, and a re-anchoring in recent years, as the work of Stock and Watson
suggests. When we think about what drives trend inflation, inflation expectations - particularly long-run
expectations - come to mind. A de-anchoring of inflation expectations would surely lead to trend
inflation becoming unanchored, whereas an anchoring of inflation expectations at a particular level
would necessarily lead to a stabilization of trend inflation and hence a decline in inflation persistence.
Do indicators of inflation expectations support this story? They certainly do. Consider the measure of
expected inflation for the coming twelve months reported by the Livingston survey. As illustrated by the
dashed line in figure 3 , this measure of expected short-run inflation - adjusted by a constant factor to
convert it from a CPI basis to a PCE basis - soared during the 1970s and then fell back markedly
during the 1980s and early 1990s. Over the past few years, the short-run series has fluctuated around
2 percent, with its month-to-month movements correlated with swings in energy prices, as one might
expect. An even more striking story is told by the survey-based measure of expected long-run inflation
used in the FRB/US model, the dotted blue line in figure 3.8 When we look at this long-run series
(which should be more closely related to expectations about policy objectives than the short-run
measure), we see that the public's expectations stood at a high level of 7-3/4 percent at the start of the
1980s, when this information first began to be collected. From that point on, however, expectations fell
steadily over the 1980s and most of the 1990s as the process of re-anchoring continued. By 1998, this
process was apparently completed, and since that time the public's expectations - at least according
to this particular measure - have been steady as a rock. Estimates of inflation compensation derived
from indexed Treasury yields have also been remarkably stable in recent years. Figure 3 also
reproduces the estimate of trend inflation produced by the Stock-Watson procedure (the solid line). As
you can see, this series more or less tracks the survey-based measures of long-run expectations,
suggesting that the anchoring of long-run inflation expectations in recent years may explain the finding
of a marked decline in inflation persistence.
deus ex
Anchoring of inflation expectations is not a machina. It must come from somewhere, and
since Milton Friedman's adage that "[i]nflation is always and everywhere a monetary phenomenon" is
still true, monetary policy must be the source of the change in the evolution of long-run inflation
expectations. During the 1960s and 1970s, the Federal Reserve and a number of other central banks
maintained a policy stance that, inadvertently or not, was too easy on average and that allowed both
actual and expected inflation to drift up markedly over many years. Since the late 1970s, however, the
Federal Reserve and many other central banks have increased their commitment to price stability, in
both words and actions. The Fed pursued preemptive strikes against rises in inflation in 1994-95,
1999-00, and in 2004-06, as well as preemptive strikes against potentially deflationary forces in the fall
of 1998 and in 2001-04. The result has been not only low and stable inflation but also, as we have
seen, a strong anchoring of long-run inflation expectations.
The pursuit of more-aggressive monetary policy to control inflation and the achievement of anchored
inflation expectations can also help explain the other stylized facts about inflation dynamics. With
expectations of inflation anchored, any given shock to inflation - whether it is from aggregate demand,
energy prices, or the foreign exchange rate - will have a smaller effect on expected inflation and
hence on trend inflation. These shocks will then have a much less persistent effect on actual inflation.
The recent experience with surging oil prices seems consistent with this story. The price of West
Texas intermediate crude oil rose from about $30 per barrel in late 2003 to a peak of almost $75 per
barrel in July of last year. During this episode, inflation appears to have been boosted only temporarily
and by a strikingly small amount, in contrast to the 1970s when oil price shocks led to large, persistent
increases in inflation.
Interestingly, monetary policy could have worked to flatten the estimated Phillips curve even without
these favorable expectational effects, simply by moving more aggressively to stabilize both inflation
and output. A theorem from the literature on optimal control states that implementing a policy of
adjusting some instrument to stabilize a particular variable has the effect, in the limit, of driving the
correlation between the instrument and the targeted variable to zero. Thus, a monetary policy that
more successfully stabilizes inflation and resource utilization could well lead to a smaller estimated
coefficient on unemployment gaps in a traditional Phillips-curve equation.
Research carried out with quite different models of the macroeconomy by my former colleagues at
Columbia, Jean Boivin and Marc Giannoni (2006), and by John Roberts (2006) at the Federal Reserve
Board, supports these conclusions. In particular, their analyses suggest that changes in the way the
Federal Reserve conducts monetary policy - including changes in both the parameters of monetary
policy reaction functions and the volatility of shocks to those functions - may account for most of the
reduction in the coefficients on resource utilization in traditional Phillips curves.9
What is particularly attractive about highlighting a better anchoring of inflation expectations as
probably the primary factor driving the changes in inflation dynamics is that this one explanation
covers so many of the stylized facts - an application of Occam's razor. Indeed, I have always become
more confident in a theory if it can explain a number of very different facts.10 This is why I am so
attracted to the view that inflation expectations are a key driving factor in the inflation process.
Of course, many other factors also influence inflation, and some of these provide other possible
explanations for the recent changes in inflation dynamics. For example, smaller coefficients on
unemployment gaps and energy prices in traditional Phillips curve equations may reflect the influence
of lower and less-variable inflation on the frequency with which firms change their prices. In the
context of a low-inflation environment, firms may have concluded that they can leave their prices fixed
for longer periods at little cost, causing inflation to be less responsive to shocks, particularly if they are
transitory. In this way, monetary policy may have affected the slope of the Phillips curve without having
affected the manner in which expectations are formed. Also, from the mid-1980s through the first
years of this decade, energy price movements were smaller and more transitory. We see this in
futures markets, in which oil prices in far-dated futures contracts moved much less than spot prices
over this period, suggesting that people expected a quick reversal in any rise in oil prices. Such
transitory shocks to energy price would presumably have a smaller effect on inflation than the
morepersistent oil price shocks of the 1970s and early 1980s. Increased globalization and other sources of
increased competition may also have lowered the sensitivity of domestic inflation to aggregate
demand, thereby flattening the Phillips curve. However, the evidence on this last point is limited and
inconclusive.11
Policy implications
These stylized facts - that inflation has become less persistent and now responds less to aggregate
demand and supply shocks - can lead to inappropriate policy advice. If we take these facts to be
structural and attributable to factors other than monetary policy, we might interpret them as suggesting
that the Federal Reserve could respond less to shocks and yet be confident that inflation would remain
at a low level. In addition, the smaller coefficient on unemployment gaps in traditional Phillips-curve
models, which seems to imply that the sacrifice ratio has gone up, might lead us to think that reducing
inflation is very costly because it requires long periods of high unemployment. As a result,
policymakers might decide that such an attempt would not be worthwhile and so would be less likely to
try to reduce inflation if it were undesirably high. If used in model simulation exercises, the flatter
Phillips curve might also suggest that getting inflation down to a particular desired level could take an
inordinately long time.
However, if we instead attribute the observed changes in inflation dynamics to better monetary policy
and a resultant better anchoring of inflation expectations, then such policy conclusions are
unwarranted. Under this alternative interpretation, the reason that inflation has become less persistent
is that monetary policy, in carrying out its dual mandate of promoting both price stability and maximum
sustainable employment, has been vigilant in maintaining a low rate of inflation on average. But if the
monetary authorities were to become complacent and to think that they could get away with not
reacting to shocks that, in their mistaken view, no longer have the potential to cause inflation to rise
persistently, then inflation expectations would surely become unhinged again. In short, complacency
deja vu
that might arise from the current low inflation persistence might result in all over again and
return us to an era like the Great Inflation. These are exactly the concerns expressed in Tom Sargent's
(2000) book on the rise and fall of U.S. inflation, in which he worries that a misunderstanding of the
inflation process might again lead to a high-inflation equilibrium.
If inflation has indeed become less persistent because better monetary policy has anchored inflation
expectations more solidly, the monetary authorities may find that they have less need to induce large
swings in economic activity to control inflation. This is a key benefit of establishing a strong nominal
anchor. Because the public has become confident that the Fed will do the right thing, expectations
now behave in a manner that makes the economy more stable to begin with. If this hypothesis is
correct, cyclical movements in interest rates need not be as great as was necessary when
expectations were unanchored. However, these favorable circumstances will persist only so long as
the monetary authorities continue to ratify the public's expectations. Consistent with its dual mandate,
the Fed must therefore continue to respond aggressively to shocks that have potentially persistent
adverse effects on both inflation and real activity. Because long-run inflation expectations are a key
driver of trend inflation, the monetary authorities need to monitor long-run inflation expectations
closely. If they find that they are losing credibility with the markets, so that inflation expectations begin
to drift and rise above (or fall below) a desired level, they must take actions to restore their credibility.
At the Federal Reserve, we understand the importance to the health of the economy of anchoring
inflation expectations. This is why Federal Reserve officials continually reiterate our commitment to
maximum sustainable employment and price stability, why we have been willing to make preemptive
strikes against both inflationary and deflationary pressures, and why we remain vigilant about
developments in the economy that could lead to persistent departures of inflation from levels that are
consistent with price stability.
My view - that recent changes in inflation dynamics result primarily from better-anchored inflation
expectations and not from structural change or simply the achievement of a persistent low rate of
inflation - implies some very good news: Potentially inflationary shocks, like a sharp rise in energy
prices, are less likely to spill over into expected and actual core inflation. Therefore, the Fed does not
have to respond as aggressively as would be necessary if inflation expectations were unanchored, as
they were during the Great Inflation era. Indeed, this can help explain why the recent sharp rises in
energy prices have had a much more benign effect on the real economy than they did in the 1970s - a
point that then-Governor Ben Bernanke made three years ago.
Although solidly anchored inflation expectations are indeed highly desirable, they could pose a bit of a
problem for monetary policy if they were at a level somewhat above or below the rate preferred by
policymakers. Under such circumstances, the central bank would likely be interested in shifting the
public's expectations in a more favorable direction. Whether such adjustment would be easy or difficult
is, unfortunately, quite uncertain because we do not understand the expectations-formation process
very well. In some early models that used the rational expectations assumption, changing inflation
expectations was relatively easy and thus implied sacrifice ratios that were extremely low, suggesting
that the monetary authorities could shift inflation at little cost. However, the historical record suggests
that permanently lowering inflation expectations may require keeping monetary policy tight for a
substantial period, resulting in considerable output and employment losses for a time.
On the other hand, as Christy and David Romer (2002) have pointed out, the Federal Reserve in the
1970s overestimated the cost of reducing inflation because estimates of sacrifice ratios by Arthur
Okun and other economists at that time proved to be too high.12 As a historical note, this provides one
explanation for the Federal Reserve's tolerance of such high inflation at the time. The disinflation after
October 1979, carried out by the Federal Reserve under the leadership of Paul Volcker using words,
procedures, and actions that were a sharp break from the past, produced a much lower cost of
disinflation than policymakers had anticipated during the 1970s.
I think these considerations leave us with fairly wide bounds on what the costs might be of
permanently shifting long-run inflation expectations that are already anchored. On the one hand, the
historical record gives us little reason to think the costs would be as minimal as the simplest models
with rational expectations might suggest. On the other hand, overly pessimistic estimates have proved
to be wrong in the past.
Implications for inflation forecasts
I have argued here that the most attractive explanation for recent changes in inflation dynamics is that
expectations have become better anchored. Inflation is now less persistent and more likely to gravitate
to a trend level that is determined by where long-run inflation expectations have settled. What
implication does this have for forecasts of future inflation? In this framework, the first priority is to
determine where inflation expectations may be anchored. This task is somewhat tricky. According to
the latest reading from the Survey of Professional Forecasters (SPF), long-term inflation expectations
are currently around 2 percent, as measured by the PCE price index that the FOMC has emphasized.
The private forecasters appear to have held this view for many years, given that long-run expectations
for CPI inflation in the SPF have been running at around 2-1/2 percent since the late 1990s, and that
the average historical wedge between the CPI measure and the PCE measure of inflation has been
about 50 basis points.13
Of course, the views of professional forecasters may not be representative of what the average person
or firm is thinking. If we turn to the financial markets, we find that inflation expectations extracted from
a comparison of the yields between Treasury inflation-protected securities (TIPS) and standard
Treasury securities seem consistent with an anchor at or perhaps a little above 2 percent in terms of
PCE inflation.14 I say "seem consistent," because we cannot be sure about at least one of the items
used in the extraction, the premium paid to investors to compensate them for inflation risk. In the case
of households, long-term inflation expectations from the Reuters/Michigan survey have been running
much higher for a number of years, at around 3 percent. However, this figure seems overstated in light
of the persistent bias found in the short-term inflation expectations reported by this survey. Correcting
for the bias, these survey results are probably more in line with PCE inflation closer to 2 percent.15 As
for firms, we unfortunately have no good data on their inflation expectations. More information on this
score would be particularly welcome, but expectations in general is an area worthy of further study.
Taken together, the data suggest to me that long-run inflation expectations are currently around 2
percent. That said, I think it should be clear that the evidence points to a range of estimates;
moreover, this range is itself uncertain because of the assumptions needed to tease point estimates
from the available data. So, although I think that 2 percent is a reasonable estimate of current long-run
expectations, I don't want to overstate the precision of this figure. We still face some uncertainty in this
regard, and policymakers must be cautious about placing too much confidence in any one estimate.
If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the
next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to
be, I think that we can be reasonably opt