FRBSF Economic Letter
2006-27; October 13, 2006
Inflation Persistence in an Era of Well-Anchored Inflation
Expectations
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 Inflation expectations and core
inflation in the United States have been remarkably stable during
the past 10 years, a dramatic
break from the pattern seen in the prior two decades, as seen
in Figure 1. Indeed, long-run inflation expectations, as measured
by the median response of the Survey of Professional Forecasters
have barely budged since 1998. Economic theory suggests that
the observed behavior of inflation may be different in a regime
of stable inflation and inflation expectations compared to regimes
in which inflation is allowed to drift for a considerable period
of time and expectations are poorly anchored. Such a change in
the behavior of inflation, if it has occurred, potentially has
important implications both for forecasting inflation and for
the appropriate monetary policy response to a change in the inflation
rate. This Economic Letter examines whether the recent stability
of inflation and inflation expectations represents a fundamental
shift in the observed behavior of inflation and explores some
possible reasons why inflation dynamics may have changed.
Has the persistence of inflation changed?
A large research literature has examined the determination
of inflation in the United States. Much of this research
focuses
on the issue of how persistent inflation is, that is, how slowly
it returns to its average value following a disturbance of
some kind. During much of the postwar period, inflation appears
to
have been extremely persistent. Indeed, Atkeson and Ohanian
(2001) find that inflation behaves like the so-called random
walk model,
where the best forecast of inflation next year is simply the
most recent observed inflation rate and the inflation rate
does not predictably tend to an average value ever.
Recent research has found evidence that inflation
persistence in the United States may have declined starting in
the early
1980s or early 1990s, when inflation became relatively low
and stable. Researchers use different methods to measure
persistence and to gauge whether the persistence has changed.
Cogley and
Sargent (2005) study a model where the inflation process
changes over time and find that inflation persistence declined
in the
1980s and 1990s. Stock and Watson (2006) examine a model
where inflation is affected by both transitory and permanent
shocks.
They find a large reduction in the magnitude of permanent
shocks to inflation during the 1980s and 1990s, implying that
inflation
has become much less persistent on average. And Levin and
Piger (2002) find that after adjusting for a shift down in the
average
inflation rate that occurred in the early 1990s, inflation
has
tended to return to its average value reasonably quickly
since the early 1980s.
The decline in inflation persistence can
also be examined in the context of a Phillips curve model of
inflation that
has
been popular for forecasting and policy
analysis. In this model, the inflation rate in the current quarter depends
on the inflation rates observed in the recent past, the
unemployment rate in the
previous quarter, and a constant. I adjust the unemployment rate for changes
in the labor market using the Congressional Budget Office's estimates of
the natural rate of unemployment. In implementing this
model using quarterly data,
I include four lags of inflation. The sum of the coefficients on the four
inflation lags provides a rough measure of the degree of
intrinsic inflation persistence,
after controlling for the effects of labor market slack on inflation as
measured by the unemployment rate. For example, if the sum of
the coefficients on
past inflation is near one, then inflation over the past
four quarters has an important
influence on the inflation rate in the current quarter, while if the sum
of the coefficients is small, the influence of past inflation
is correspondingly smaller.
In order to see whether the
intrinsic persistence in inflation has changed over the past
few decades, I estimated this
Phillips curve model over and over
for
different data samples. In each case, the sample ending point is held
fixed at the most recent observation of the second quarter of
2006. The sample
start date
ranges from the first quarter of 1980 to the fourth quarter of 1999.
Because many of these data samples are quite short, I estimate
this model using
Rudebusch's (1992) median-unbiased estimator that corrects
for the bias in standard least
squares estimation that can occur with small samples. I look at two popular
measures of "core" inflation based on: (1) the price index
of personal consumption expenditures (PCE), and (2) the Consumer Price
Index
(CPI). In both cases, the "core" price
index excludes prices of food and energy components. For the CPI, I use
the Bureau of Labor Statistics' methodologically consistent series that
corrects for changes
in methodology over the past few decades.
 The estimated sum of coefficients
on lagged inflation falls well below one for samples that begin in
the early 1990s or later, indicating that
inflation
has
become much less persistent in the past 15 years. Figure 2 shows the
resulting estimated sum of the coefficients on lagged inflation, where
the date on
the horizontal axis indicates the starting date of the sample used
for estimation. The decline in the estimated degree of inflation
persistence
is evident in
both measures of core inflation.
Although the decline in the point estimates
of the sum of the coefficients for more recent samples shown
in the figure is clear to the eye, standard
statistical tests do not confirm this. This inability to find clear
evidence of a break
reflects
the imprecision of the coefficient estimates and is consistent with
the findings of Pivetta and Reis (2006) and indicates that, from
a purely
statistical point of view, the low degree of inflation persistence
observed in recent
years may
well be due to random variation in the data rather than a true shift
in the
observed behavior of inflation.
Interpreting the change in the observed
behavior of inflation
One interpretation of the contemporaneous attainment
of stable inflation and inflation expectations and low inflation
persistence
is that
we have experienced
a run of good luck. This is the view of those who think inflation
persistence has always been high and the recent evidence is not
compelling enough
to convince them that anything has changed. Alternatively, we may
have been "lucky" in
that the magnitude of "permanent inflation shocks" has
fallen, as in the analysis of Stock and Watson (2006).
A different
interpretation is that the change in the observed behavior
of inflation reflects the effects of a past fundamental shift
in monetary policy
whereby
the Federal Reserve now systematically acts to stabilize core
inflation around a
constant long-run "target" and has gained credibility
with the public that it will continue to do so in the future.
The observed high degree of inflation
persistence in the past puzzled many macroeconomists, as discussed
in Fuhrer and Moore (1995). Textbook theories of price dynamics
with forward-looking expectations
typically predict that inflation will display relatively low
persistence, meaning that the inflation rate will tend to move
close to its
average value within,
say, a year or two. Thus, the recent behavior of inflation appears
to be more consistent with standard theories than its past behavior
was.
The change in the observed persistence of inflation
may reflect the effects of a shift from poorly anchored inflation
expectations
in
the past to
well-anchored expectations today. Erceg and Levin (2003) show
that inflation will appear
to
be highly persistent if the central bank changes its inflation
objective but the public is uncertain of the change, even in
a model where
inflation displays
very little persistence if the long-run inflation objective
is constant. In this view, the very high observed degree of inflation
persistence
seen in the
past
reflects the conduct of monetary policy during this period,
which
led to the sustained rise in inflation in the 1970s and the
disinflations of the
early
1980s and early 1990s. Similarly, in the model of Orphanides
and Williams
(2005), if
long-run inflation expectations are well anchored, then inflation
will be less persistent than if the public is uncertain about
the long-run
inflation objective.
An extreme but nonetheless illuminating
example of how changes in monetary policy regimes affect the
behavior of inflation
is found
by comparing
inflation dynamics
in two very different monetary policy regimes. Ball (2000)
shows that variations of the random walk model describe inflation
reasonably
well
over 1960-1999,
but these models perform very poorly in the period of 1879-1914
when the monetary regime was very different and inflation
displayed little
persistence.
In the
pre-World War I period, a reasonable model is one where inflation
returns to a sample mean with only a modest degree of persistence.
Conclusion
Recent research finds evidence suggesting that the
observed degree of inflation persistence may have become far
lower
in the past
decade than
it was in
the prior two decades. This finding is consistent with
the prediction of theoretical
models
when monetary policy systematically acts to stabilize inflation
around a constant long-run target and has credibility with
the public. If
true, then
one should
expect inflation to display low persistence in years to
come as long as policy continues to act in the pattern of
the
past decade
and
inflation expectations
remain well anchored. This conclusion is admittedly quite
tentative. Because
I am looking at a relatively short period of time, it is
simply not possible to determine unequivocally whether
the observed
shift in
the observed
persistence in inflation represents a sustained change
in the observed behavior of
inflation or instead is due to random causes.
Importantly,
even taken at face value, this evidence regarding possible
shifts in the persistence of inflation may only
reflect changes in
the correlations
in the data, possibly induced by changes in the behavior
of monetary policy, and not correspond to any change
in the true
structure
of the economy.
Therefore, the recent low level of inflation persistence
cannot be taken as a given
in designing monetary policy: if policy acts in ways
to create a high degree of
inflation
persistence, then the public's expectations would eventually
shift to reflect that reality.
John C. Williams
Senior Vice President and Advisor
References
[URLs accessed October 2006.]
Atkeson, Andrew, and Lee E. Ohanian. 2001. "Are
Phillips Curves Useful for Forecasting Inflation?" FRB Minneapolis
Quarterly Review 25(1), pp. 2-11.
http://www.minneapolisfed.org/research/QR/QR2511.pdf
Ball,
Laurence. 2000. "Near-Rationality and Inflation in
Two Monetary Regimes." NBER Working Paper 7988.
Cogley,
Timothy, and Thomas J. Sargent. 2005. "Drifts
and Volatilities: Monetary Policies and Outcomes in the
Post WWII
U.S." Review of Economic Dynamics 8, pp.
262-302.
Erceg, Christopher J., and Andrew T. Levin. 2003. "Imperfect
Credibility and Inflation Persistence." Journal
of Monetary Economics 15, pp. 915-944.
Fuhrer, Jeff,
and George Moore. 1995. "Inflation Persistence." The
Quarterly Journal of Economics, pp. 127-159.
Levin,
Andrew T., and Jeremy M. Piger. 2002. "Is
Inflation Persistence Intrinsic in Industrialized Economies?" FRB
St. Louis Working Paper 2002-023E.
http://research.stlouisfed.org/wp/2002/2002-023.pdf
Orphanides,
Athanasios, and John C. Williams. 2005. "Imperfect
Knowledge, Inflation Expectations, and Monetary Policy." In The
Inflation-Targeting Debate,
eds. Ben S. Bernanke and Michael Woodford. Chicago:
University of Chicago Press, pp. 201-234.
Pivetta, Frederic,
and Ricardo Reis. 2006. "The
Persistence of Inflation in the United States." Journal
of Economic Dynamics & Control, forthcoming.
Rudebusch,
Glenn D. 1992. "Trends and Random Walks
in Macroeconomic Time Series: A Re-examination." International
Economic Review 33 (August), pp. 661-680.
Stock,
James H., and Mark W. Watson. 2006. "Why Has Inflation
Become Harder to Forecast?" NBER Working Paper
12324 (June).
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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