FRBSF Economic Letter
99-18; May 28, 1999
 Economic
Letter Index
Output and Inflation: A 100-Year Perspective
While economists generally accept that monetary policy can influence
nominal variables such as the price level and inflation, they continue
to debate the relationship between monetary policy and real variables
such as the unemployment rate and real GDP. During the early 1960s, many
economists and policymakers believed that policy could exploit a stable
trade-off between inflation and real economic activity. One version of
the hypothesized trade-off, originally described by A.W. Phillips (1958)
using U.K. data from 1861-1957, implied that policymakers could permanently
lower unemployment by generating higher inflation. Some years later, economists
Edmund Phelps (1967) and Milton Friedman (1968) argued persuasively that
any such trade-off was bound to be short-lived: once people came to expect
the higher inflation, monetary policy could not keep unemployment below
its long-run equilibrium or "natural" level. This claim was later borne
out by the experience of the 1970s, when rising U.S. inflation did not
bring about the lower unemployment rates promised by the Phillips curve.
On the contrary, higher inflation coincided with higher unemploymenta
combination that became known as "stagflation."
In the late 1990s, the situation is precisely the reversethe U.S. economy
exhibits low inflation combined with low unemployment. Some commentators
seem to view this combination as a puzzle or breakdown in the traditional
relationship between inflation and real economic activity. This Economic
Letter challenges such a view by putting the recent data into a 100-year
historical perspective.
Stabilization policy
Validation of the Phelps-Friedman argument by the experience of the 1970s
still left open the possibility that policymakers might exploit a short-term
or transitory link between inflation and real activity to smooth business
cycle fluctuations. For example, the Fed might pursue an expansionary
monetary policy to stimulate aggregate demand when real activity was "too
low" and adopt a contractionary monetary policy to reduce aggregate demand
when real activity was "too high"all the time recognizing that no permanent
trade-off between inflation and real activity exists. Indeed, one can
see how this principle might be used nowadays to guide the Fed in pursuit
of its legally mandated goals to promote "maximum" employment and "stable"
prices (see Federal Reserve Bank of San Francisco, 1999).
Efforts to smooth business cycles using monetary policy face some difficult
problems. First, history has shown that monetary policy affects the economy
only through long and variable lags. Second, a policy of "leaning against
the wind" requires policymakers to decide in real time (using preliminary
data) whether economic activity is "too low" or "too high" relative to
some benchmark. Benchmarks such as the natural rate of unemployment or
the long-run trend of real GDP cannot be observed directly, however. These
must be estimated from available data by combining economic theory, statistical
analysis, and sound judgment.
Estimating the long-run trend in real
output
One very simple way to estimate the long-run trend of real GDP per person
is to fit a straight line through the data. This would be appropriate
if one believes that technological change occurs at a constant rate, while
transitory shocks generate fluctuations around the long-run trend. Many
economists believe, however, that technological change occurs unevenly
and is influenced by many factors, such as the training and education
of the workforce, the amount of resources devoted to inventive activity,
and tax policy, to name a few. If this were true, then the assumption
of an invariant long-run trend could lead one to the mistaken conclusion
that observed movements in real GDP are due to transitory shocks pushing
the economy away from trend (thus calling for a monetary policy response)
when in fact the long-run trend itself has shifted. To avoid such a mistake,
it is desirable to employ a trend measure that is capable of accounting
for shifts in the long-run trend of real GDP. One way this might be done,
for example, would be to fit a piecewise straight line through successive
midpoints of business cycle expansions. This approach has a serious drawback,
however, because the midpoint date is not known until after the expansion
has ended. Policy decisions must be made in real time without the benefit
of such hindsight.
John Cochrane (1994) has suggested a way of using consumption data to
help account for shifts in the long-run trend of real GDP. Cochrane's
idea is based on the permanent income hypothesis, which says that people's
consumption decisions depend primarily on their "permanent" income, i.e.,
income that is expected to persist into the future. According to this
theory, transitory changes in income do not have much impact on consumption;
people use saving and borrowing to maintain a smooth pattern of consumption
when hit by transitory income shocks. If we observe a change in income
that is not accompanied by a change in consumption, then we can infer
that people view the income change as transitory. On the other hand, if
we observe simultaneous changes in income and consumption, then we can
infer that people view the income change as permanent. Individual consumers
have first-hand knowledge regarding the future prospects of their employer
(and their employer's industry) and hence are in good position to judge
whether changes in their own income are likely to be permanent or transitory.
A shift in the long-run trend of real GDP will affect people's permanent
income and should thus be accompanied by a change in consumption. By regressing
output data on consumption data (both of which are observable in real
time), these shifts can be automatically incorporated into a measure of
trend output. The resulting "output gap," i.e., the deviation of real
GDP from trend, should provide an informative signal about where the U.S.
economy is operating relative to its long-run potential (for additional
discussion, see Cogley and Schaan 1995).
Figure 1 plots private real
GDP per person (real GDP less government expenditures) for the period
1890-1998 together with a consumption-based trend. This approach places
the U.S. economy close to its long-run trend during the late 1990s. The
strong growth of real GDP over this period could thus be interpreted as
reflecting an upward shift in the economy's ability to produce goods and
servicesa shift that people view as permanent based on the strong growth
of their consumption. Given this interpretation of the data, the current
U.S. output gap is actually quite small in comparison to some other periods
of fast economic growth, such as the early to mid-1960s.
Estimating the long-run trend in inflation
Figure 2 plots U.S. inflation
over the period 1890-1998. As with real GDP, it is useful to construct
a long-run trend of inflation so that short-term or transitory movements
can be defined as deviations from the trend. Here we adopt a trailing
five-year moving average as our measure of trend inflation, which approximates
an exponential smoothing technique. As noted by Cogley (1998), this technique
accounts for periodic shifts in what might be viewed as the Fed's long-run
inflation target and has the advantage that the trend can be computed
in real time (unlike a centered moving average trend).
The trailing five-year moving average also can be interpreted as a measure
of expected inflation. In particular, people are likely to use observations
about past inflation to help make predictions about future inflation.
According to the Phelps-Friedman argument, only the unexpected component
of inflation (the deviation from trend) should influence real economic
activity. Figure 2 shows that U.S. inflation is slightly below trend in
the late 1990sa situation that has been labeled a puzzle by some commentators,
given the strong growth of real GDP over the same period.
Short-term movements in output and inflation
Figures 3 and 4 plot short-term
movements in output and inflation. The "output gap" (private real GDP
minus the consumption-based trend) consistently falls during recessions.
The "inflation gap" (inflation minus the moving average trend) usually
falls during recessions but is sometimes observed to rise during these
periods (Figure 3). An example
is the 1974 recession when OPEC production cutbacks led to a 68 percent
increase in the price of crude oil. Thus, the presence of transitory supply-shocks
(which by definition should be separated from shifts in the long-run trend)
help to explain why the output and inflation gaps do not always move in
the same direction. Notice that the two gap measures appear to be going
in opposite directions at the end of our data sample in 1998 (Figure 3).
It is worth noting that the price of crude oil dropped by nearly 40 percent
in 1998an event that can be viewed as a favorable transitory supply shock.
Despite periods when the two gap measures move in opposite directions,
the correlation between short-term movements in output and inflation is
positive for the whole sample period (correlation coefficient of 0.18),
the post-WWII sample period (correlation coefficient of 0.20), and the
1917-1946 sample period, which includes two world wars and the Great Depression
(correlation coefficient of 0.34). This positive correlation accounts
for the "traditional" view of the short-term output-inflation relationship.
It also suggests that transitory demand shocks (which cause the two gap
measures to move in the same direction) are an important feature of the
data.
Data for 1998 place the U.S. economy close to the center of the scatter
diagram with an inflation rate that is slightly below the best-fit regression
line (Figure 4). Given the
statistical uncertainty in the position of the best-fit line and the possibility
of a transitory supply shock from falling oil prices, the 1998 output-inflation
combination should not be viewed as "puzzle" or a breakdown in the historical
relationship.
Kevin Lansing
Economist
Jeffrey Thalhammer
Research Associate
References
Cochrane, John H. 1994. "Permanent and Transitory Components of GNP and
Stock Prices." Quarterly Journal of Economics 109(1), pp. 241-265.
Cogley, Timothy. 1998. "A Simple Adaptive Measure of Core Inflation."
Federal Reserve Bank of San Francisco Working Paper 98-06.
___, and Desiree Schaan. 1995. "Using Consumption to Track Movements
in Trend GDP." FRBSF Weekly Letter 95-28 (September 1).
Farmer, Roger E.A. 1999. Macroeconomics. South-Western College
Publishing.
Federal Reserve Bank of San Francisco. 1999. "U.S. Monetary Policy: An
Introduction." FRBSF Economic Letter 99-01
(January 1).
Friedman, Milton. 1968. "The Role of Monetary Policy." American Economic
Review 58, pp. 1-17.
Phelps, Edmund S. 1967. "Phillips Curves, Expectations of Inflation and
Optimal Unemployment Over Time." Economica 34, pp. 254-281.
Phillips, A.W. 1958. "The Relation Between Unemployment and the Rate
of Change of Money Wage Rates in the United Kingdom, 1861-1957." Economica
25, pp. 283-289.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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