Extract from Bob Gay’s piece ‘Regime Change: Inflation’
The longstanding inverse relationship between inflation and economic slack seems to have weakened dramatically.
The Demise of the Phillips Curve. Almost 60 years ago, an economist named A.W. Phillips published an empirical study that showed periods of low unemployment were associated with rising inflation. The finding was intuitively plausible and meshed nicely with economists’ belief in how competitive markets should work – namely, prices rose when resources including workers were in short supply. By the 1970s, however, that inverse correlation was coming unglued as unemployment ratcheted higher and so did inflation. Economists scrambled to salvage the theory in other forms. Notably, the Fed staff introduced the empirical concept of ‘potential GDP’ that reflected the highest level of GDP consistent with stable prices. Actual output could exceed its potential but only at higher unit costs. The narrow line of causation from tight labour markets to higher wages and prices, as depicted by the Phillips curve, faded from use at the Fed, albeit not from the lexicon of the financial media.
My version of the output gap as a percent of GDP has been a reliable depiction of the ebb and flow of core inflation for more than 50 years. Whenever real GDP rose above its potential inflation rose whereas negative output gaps led to disinflation. As the globalised economy evolved, the parameters of this model morphed as well. For one thing, inflation always lagged ‘full employment’ (defined as an output gap of zero) by about one year. Now that lag seems to have lengthened to six quarters. Using that rule of thumb and my estimate of an output gap of zero as of this past summer, we can see why financial markets and most forecasters are so sanguine about inflation in the near term. In my opinion, though, structural changes in the world economy have had a much deeper and more long-lasting impact on inflation than merely delaying its response to full employment by a few quarters.
Another difficulty with the output-gap model is to know where we stand, especially after eight years of expansion. Even a small error in the estimates for potential GDP that underpin the model would result in a large error in estimating the magnitude of the current output gap. What we know is that potential growth has declined almost in half since 2003 when a break in the trend appears evident. My model uses 1.8% as the long-term growth trend consistent with stable inflation. The Fed staff now uses an estimate of about 2%. The same factors that have stultified growth, including demographics, outsourcing, technological obsolescence and drug abuse, also have affected the measured unemployment rate and hence the Phillips curve relationship by discouraging labour force participation. These structural and socioeconomic factors, rather than market forces such as unfilled job vacancies, explain why measured unemployment has fallen to about 4% without creating much pressure on wages.
The most serious concern, however, is that inflation is not as sensitive to economic slack as it once was. One might dismiss this observation as an inherent by-product of low inflation: wages and prices are sticky when it comes down to cutting them. Incumbent workers in particular are resistant to pay cuts, even in the worst of times. That example speaks to why market-based theories of wage determination are the weakest link in models of inflation and indeed in much of general equilibrium economic theory. In reality, market forces play a relatively minor role in setting employee compensation. Rather, conditions in the product market including productivity, profitability, bargaining power and customary wage comparisons predominate. That is where to start in rethinking the implications of regime change.