Discussion of Why Has Inflation Remained So Low for So Long? By - PowerPoint PPT Presentation

Discussion of “Why Has Inflation Remained So Low for So Long?” By Robert King (with many comments that are only partly motivated by Bob’s paper) October 15, 2016 Jeff Fuhrer, EVP, Federal Reserve Bank of Boston 1

6  Great Recession produced an enormous 4 output/employment gap 2  Yet inflation fell only a 0 little Output gap -2  This may be the larger Headline inflation puzzle Core inflation -4  The quick and dirty -6 answer: Long-run -8 expectations remained 2007:Q3 2007:Q4 2008:Q1 2008:Q2 2008:Q3 2008:Q4 2009:Q1 2009:Q2 2009:Q3 2009:Q4 2010:Q1 2010:Q2 2010:Q3 2010:Q4 2011:Q1 2011:Q2 2011:Q3 2011:Q4 well-anchored  “Anchored expectations” doesn’t mean “inflation will not budge, even during a huge recession” 2

 Compared to the 2% target Index, Dec. 2007-100 100 105 110 115 120 125 95 2007:Dec 2008:Apr 2008:Aug 2008:Dec 2009:Apr Total PCE Core PCE 2% price line, core PCE 2009:Aug 2009:Dec 2010:Apr 2010:Aug 2010:Dec 2011:Apr 2011:Aug 2011:Dec 2012:Apr 2012:Aug 2012:Dec 2013:Apr 2013:Aug 2013:Dec 2014:Apr 2014:Aug 2014:Dec 2015:Apr 2015:Aug 4-5% gap Cumulative 2015:Dec 2016:Apr 2016:Aug 3

1.2 1.4 1.6 1.8 2.2 1 2 2011:Q4 2012:Q1 2012:Q2 2012:Q3 2012:Q4 2013:Q1 2013:Q2 2013:Q3 2013:Q4 2014:Q1 2014:Q2 2014:Q3 2014:Q4 2015:Q1 Core Pce 2015:Q2 2015:Q3 2015:Q4 2016:Q1 SPF 2016:Q2 4

 RMSE for inflation forecasts, recent history RMS Forecast errors, SPF Core PCE, 2007-present Horizon RMSE Current quarter 0.50 t+1 0.58 t+2 0.60 t+3 0.60 t+4 0.58  Current core PCE: 1.7% (12-month)  0.3 ppt below target is well within forecast accuracy  We’ll come back to this. 5

 The output/employment gap is not yet zero  Real marginal cost/labor share remains low, even accounting for trend  So inflation has been a little low  That’s a pretty good Squawk Box explanation, but you might want something more substantial… 6

 Depends on what modeling framework one uses  Accelerationist Phillips curve?  New-Keynesian Phillips curve?  So-called “anchored expectations” “model”? 7

 Accelerationist Phillips curve (toy version) π = π − β − + ε * ( ) U U − 1 t t t t t  Defines the change in inflation; CB influences changes so as to attain its target  Once inflation is below the central bank’s target, must have a period of below-NAIRU unemployment to get it back up  Could be that’s why inflation is stubbornly low today  But look at this model’s forecast for inflation during recession: 4 Flatter PC 2 0 Estimated PC -2 Toy PC -4 -6 -8 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 8 of 15

 Inflation importantly linked to “fundamental inflation”— the discounted expectations of output or real marginal cost π = ωπ + − ω π + µ F (1 ) − 1 t t t t ∞ = ∑ π λ β F j E s + t t t j = 0 j  Papers differ in their claims for the success of the NKPC in explaining inflation during the GR  Del Negro et al find a model that fits the data fairly well  Next slides present some estimates of fundamental inflation  NB: Expectations are perfectly anchored in this model 9

 Method: Like King- Watson (2012). 8- Estimates of fundamental inflation variable VAR Various estimation samples, discount factors 4 (includes long-run Core PCE Fundamental inflation infl. expectations, 2 output, wages, ulc, C, 0 I, ff) -2  Add an identity Percent -4 defining fundamental inflation, using VAR -6 forecasts of labor -8 share -10 Labor share not detrended  Trend in labor share is a serious problem -12 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Year  King and Watson point Samples include or exclude the 1980s, the Great Recession Discount factors from 0.5 to 0.98 this out 10

Use detrended  Estimates of fundamental inflation labor share Various estimation samples, discount factors Where does trend 6  Core PCE come from? Fundamental inflation 5 Most of these  estimates of 4 “fundamental” 3 inflation have a hard time 2 explaining recent Percent inflation 1 They generally  0 suggest that inflation should -1 have been even -2 lower than it has Labor share detrended been -3 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Similar results Year  Samples include or exclude the 1980s, the Great Recession using output gap Discount factors from 0.5 to 0.98 instead of L share 11

 The simple version π = π + − + ε π = π * * LR LR ( ) ; ? a y y t t t t t CB  As output gap disappears, inflation goes to long-run expectation  Somewhat like NKPC, but only LR expectations are explicit  Important that the long-run expectation remain “anchored”—i.e. fixed at CB target  If not, inflation could settle somewhere other than CB target, even as output goes to equilibrium  How does a CB make sure that is the case? 12

π = π + π + − − π + − + ε LR * (1 ) ( ) l l l l a y y − − 5 1 1 2 2 1 2  They kinda do t t t t t t t Core PCE  Long-run 4.5 Fitted value expectations capture Forecast 4 the trend 3.5  The gap captures some of the up and 3 down prior to and 2.5 during the recession 2  Puzzle for this model: Output gap is 1.5 probably nearly closed, possibly 1 turning positive in the 0.5 coming years 1985 1990 1995 2000 2005 2010 2015 2020 Year  But inflation is still Long-run expectations = FRB/US PTR; output gap uses CBO below 2% estimate of potential GDP; estimation from 1998:1-2016:2  But not a huge puzzle 13

 The model says that once we get output to equilibrium, inflation equals long-run expected inflation  But not explicitly because the central bank is acting to move inflation toward the target  In fact, the CB could just target output, and inflation would always return to the long-run expectation π = π + π + β − π = π * LR LR ( ); * l y y − 1 1 t t t t t t = − σ − π − ( 2) y Ey f E + + 1 1 t t t t = + π + − * 2 * ( ) f a y y t y t t  The model above behaves just fine with NO policy response to inflation— that’s a little different (certainly not true for standard models, e.g. with NKPC or OKPC)  Not just an academic point—this is about how CB’s ensure that inflation returns target, a central issue today. 14

 Bob identifies a few surprises (possibly puzzles)  2008 decline; return to 2% in 2011; below-2% inflation recently  How big are these surprises/puzzles? Compare to history. Tealbook forecast errors, core CPI, 2008-2010 Tealbook forecast errors, core CPI, 1990-2010 Forecast-actual Forecast-actual 1.5 2 1-qtr. 1-qtr. 4-qtr. 1.5 4-qtr. 1 1 0.5 0.5 0 0 -0.5 -0.5 -1 -1 -1.5 -2 -1.5 08:Q1 08:Q3 09:Q1 09:Q3 10:Q1 10:Q3 11:Q1 -2.5 Realization date 1985 1990 1995 2000 2005 2010 2015 Not so large, nor too one-sided. Realization date 15

Phillips curve model with SPF expectations (long- and short-run) Survey-based  3 PC does OK during recent 2.5 period Suggests that 2  a better 1.5 understanding of 1 expectations Core CPI inflation may improve In-sample fit 0.5 our imperfect Out-of-sample forecast understanding 0 of inflation 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Year π = π + − π − − ,10 ,1 ,1 * SPF yr SPF q SPF q (1 ) ( ) a a b U U t t t t t 16

Scatter plot relating forecast revisions to lagged Intrinsic persistence in discrepancy between individual and median forecast  expectations formation (macro evidence-Fuhrer ith forecaster’s revision 2015) That is, (short-run)  expectations add persistence Slope = -0.6 beyond what is in the series p -value = 0.000 for which they are forming expectations Micro-data on expectations  Discrepancy between ith lagged forecast and lagged median display a specific kind of “intrinsic persistence”- Dependent variable: Revision from t-1 to t for forecast period Fuhrer 2016 Lagged discrepancy t+1 t+2 t+3 t+1 t+2 t+3 π − π -0.58 -0.56 i Median The source: Forecasters and  + − + − (0.000) (0.000) t 1, t 1 t 1| t 1 households keep their -0.54 -0.53 π − π i Median forecasts close to the lagged + − + − (0.000) (0.000) t 2, t 1 t 2| t 1 -0.61 -0.61 central tendency of forecasts π − π i Median (0.000) (0.000) + − + − 3, 1 3| 1 t t t t What’s the evidence? (SPF, π −  0.01 0.03 0.05 i 1 (0.648) (0.019) (0.000) Michigan, Euro SPF) t Other forecast N N N Y Y Y controls Observations 3274 3257 3180 3029 3017 2960 17

 Intuition is simple: Inflation during recession and recovery with inertial expectations  During Great Recession, expectations inertia 2 tempered the decline in inflation 1.5  See this in the survey- based PC  Similarly, during recovery, 1 expectations inertia slows Simulated, with expectations inertia Acutal core PCE (12-qtr.) the increase toward the 0.5 long-run target  Simple macro model with 0 this kind of explicit 0 8 16 24 32 40 48 Quarters expectations inertia illustrates these effects: 18