Have Inflation Dynamics Changed?
Edward S. Knotek II
Federal Reserve Bank of Cleveland, 11.28.17
Using a flexible statistical model to project inflation outcomes into the future, this Commentary finds that the most likely path for inflation based on recent inflation dynamics is generally similar to what would have been expected given inflation dynamics in the late 1990s, but there is more uncertainty around the forecast now than in the late 1990s.
After rising in the second half of 2016 and in the early part of 2017, inflation as measured by the price index for personal consumption expenditures (PCE) began to reverse course unexpectedly. While PCE inflation has been below 2 percent for most of the expansion following the Great Recession, its recent decline came in the midst of a low and falling unemployment rate, stable oil prices, and a depreciating dollar. These forces would not ordinarily be expected to put downward pressure on inflation. This situation has posed something of a “mystery” for monetary policymakers (see, e.g., Yellen 2017b). Seeking to explain this disconnect between inflation and its fundamental drivers, some economists have raised questions about whether inflation dynamics have recently changed, perhaps as a result of ongoing globalization, technological innovation, or shifts in the competitive environment related to the internet, among other factors.1
In this Commentary, we look at inflation through the lens of a flexible statistical model that can capture time-variation in inflation dynamics and in the relationship between inflation and unemployment. Using this model, we generate two sets of inflation forecasts. The first forecast is based on the most recent behavior of inflation and the unemployment rate. In the second forecast, we assume that inflation dynamics are governed by the behaviors we saw in the late 1990s—another period in which both the unemployment rate and inflation were notably low, but also one in which globalization and internet commerce may have been putting less downward pressure on inflation. In terms of the most likely paths going forward, the point forecasts for inflation and unemployment from these two approaches are generally similar—and, if anything, the projection based on recent inflation dynamics calls for a more rapid rise of inflation to 2 percent today than would have been the case in the late 1990s. But there is more uncertainty surrounding the point forecasts now than in the late 1990s, consistent with an economy that is now subject to larger shocks and a looser relationship between inflation and unemployment than in the past.
Capturing Time Variation
To adequately address whether inflation dynamics may have changed and what those changes imply for the inflation outlook, we need a model for forecasting inflation, a method for estimating the model that can pick up changes in inflation dynamics, and a suitable base period for comparison.
For the model, we have chosen a bivariate vector autoregression (VAR) using quarterly data on the unemployment rate and core PCE inflation, which excludes food and energy prices. The Phillips curve typically relates inflation to the unemployment rate. While our model is related to the literature on Phillips curves, the VAR specification is agnostic about the precise form that the relationship between core inflation and the unemployment rate might take.2
For the estimation method, we use a flexible statistical modeling approach that allows us to capture potential changes in economic relationships over time. This approach allows for changes in the parameters of the VAR model over time and changes in the typical sizes of the shocks hitting the model. Technically, we estimate the VAR allowing for time-varying parameters and stochastic volatility (TVP-SV). TVP-SV models were developed by Cogley and Sargent (2005) and Primiceri (2005).3 D’Agostino et al. (2013) show that small TVP-SV models produce relatively accurate inflation forecasts, even for forecast evaluation periods starting in the 1980s, when forecasting inflation became more difficult.4
Finally, for the comparison point with the past, we use 1999:Q3. In selecting the comparison point, we sought out a time in which economic conditions bore similarities to today’s and forces that have been proposed as weighing on inflation—such as internet commerce and globalization—were arguably less important than they are today. Regarding the latter forces, the internet as an online marketplace was in its early stages in the late 1990s, and China had not yet entered the World Trade Organization. In terms of economic conditions, core PCE inflation was running below 2 percent in the late 1990s, while the unemployment rate was relatively low and declining (figure 1). In particular, the unemployment rate averaged 4.2 percent in 1999:Q3 while trailing four-quarter core PCE inflation was 1.3 percent; for comparison, the unemployment rate averaged 4.3 percent in 2017:Q3, and trailing four-quarter core PCE inflation was 1.3 percent.
Inflation: Still Partying Like It’s 1999?
A key benefit of the TVP-SV framework is that we can capture changes in inflation dynamics—even very recent changes that might only have occurred near the end of our estimation sample.5 These changes can take on a variety of forms, including changes in the persistence of our variables of interest; changes in the relationship between core inflation and the unemployment rate—that is, the slope of the Phillips curve; and changes in the model’s estimates of where the economy is likely to go in the long run.6 To see how the economy has changed since the late 1990s, we estimate the model twice, once using data through 1999:Q3 to capture circa 1999 inflation dynamics and then a second time using data through 2017:Q3 to capture circa 2017 inflation dynamics.7
Table 1 reports key statistics from the two estimations. While the persistence of the unemployment rate is similar across the two periods, core inflation has become less persistent: The sum of the lagged inflation coefficients has decreased from 0.98 in the 1999:Q3 estimation to 0.87 in the 2017:Q3 estimation. The slope of the Phillips curve is just a little bit flatter in the later estimation: The unemployment rate has a slightly smaller influence on inflation circa 2017 than it did circa 1999, though the influence of the unemployment rate on inflation was already small in the late 1990s. But in the longer run, the two estimations expect the economy to converge to nearly identical places. Whether estimating using data through 1999 or 2017, the model calls for inflation to converge to 2 percent, while the unemployment rate converges to 4.3 percent when estimating through 1999 and 4.4 percent when estimating through 2017.8 So in both cases, the forces keeping inflation below 2 percent ultimately are viewed as transitory.
|1999:Q3 estimation||2017:Q3 estimation|
|Phillips curve slope||−0.07||−0.06|
|Long-run unemployment rate||4.3||4.4|
Source: Authors’ calculations.
Notes: Persistence and slope estimates are based on posterior mean parameter estimates. Long-run estimates are median forecast values after 10 years.
Using the recent data on core PCE inflation and the unemployment rate as a starting point, we take the estimated parameters based on the samples ending in 1999 and 2017 and produce two sets of forecasts, one based on circa 1999 inflation dynamics and another based on circa 2017 inflation dynamics. Figure 2 shows the inflation forecasts.9 The solid lines show the respective point forecasts, or most likely paths, from the two estimations. The corresponding dashed lines show the 70 percent probability bands around each point forecast; that is, they show the range of future inflation outcomes that the models expect will occur 70 percent of the time, with inflation expected to fall outside the bands 30 percent of the time. We make two observations.
First, we view the point forecasts for core PCE inflation as generally similar: Based on the inflation dynamics from either estimation period, the most likely path for inflation is a rising trajectory over the forecast horizon back toward 2 percent. If anything, the inflation projection based on circa 2017 dynamics is firmer than the projection based on circa 1999 dynamics. This finding comes largely from the fact that inflation is currently less inertial recently than it had been, a situation which allows inflation to return to its longer-run level more quickly in the recent period than it would have in the late 1990s. In both cases, the low level of the unemployment rate—which is below its longer-run level—is putting upward pressure on inflation via Phillips curve effects, but the strength of this effect is quantitatively similar for both forecasts. These results are at odds with the conjecture that growing forces—such as rising pressures from ongoing globalization and increased price competition from the internet—are depressing inflation and will continue to do so going forward.10
Second, considerable uncertainty surrounds these projections, but there is more uncertainty surrounding the point forecasts of inflation now than in the late 1990s. The differences in uncertainty are illustrated in the figure, because while the lower ends of the 70 percent probability bands are essentially identical across the two estimation periods, the upper bands are higher in the circa 2017 case than in the circa 1999 case. We find similar results for the unemployment rate, for which the 70 percent probability band is wider in the circa 2017 forecasts compared with that of the circa 1999 forecasts. The changing width of these probability bands is consistent with an economy that is now subject to larger shocks and a looser relationship between inflation and unemployment than in the past.
Given that the forecasts call for a firming of inflation, what actually occurred after 1999, when core PCE inflation and the unemployment rate were both near current levels? A common saying in the financial services industry is that past performance is no guarantee of future results—and that, in this case, may turn out to be a good thing. As figure 1 shows, core PCE inflation began to pick up in 2000 and was arguably headed back toward 2 percent—that is, until the unemployment rate rose with the 2001 recession and core inflation drifted back down. As the economy recovered, core PCE inflation did eventually make it to 2 percent, but not until 2004:Q4.
In this Commentary we use a flexible statistical model that can capture potential variation in inflation dynamics over time. We show that inflation forecasts based on inflation dynamics in two time periods, one in the late 1990s and another one in 2017, would both put inflation on a rising trajectory back toward 2 percent, with the forecast based on recent data suggesting the rise will be faster than would have been suggested by the late 1990s data. But we also document greater uncertainty around the more recent forecast path, consistent with an economy that is now subject to larger shocks and a looser relationship between inflation and unemployment than in the past.