The “impossibility” of inflation

For the past 25 years, inflation (PCE-Core) has remained low and stable. Nevertheless, many are worried that inflation is about to “take-off”.

In a recent piece, Greg Ip writes, “Why an unpleasant inflation surprise could be coming”:

Inflation is going to head up this year — on that there isn’t much debate.

… If inflation turns up, economists have long assumed it would do so slowly, giving the Fed plenty of time to respond. But Michael Feroli of J.P. Morgan notes this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

A case in point: in 1966, inflation, which had run below 2% for nearly a decade, suddenly accelerated to over 3%. Some of the circumstances echo the present: unemployment had slid to 4%, taxes had been cut and federal spending for the Vietnam War and Lyndon Johnson’s “Great Society” programs was surging. Deutsche Bank economists note the budget deficit jumped by more than 2% of gross domestic product between 1965 and 1968, similar to what they project between 2016 and 2019. Except in recessions, stimulus of this size “is unprecedented outside of these two episodes,” they said.

In his latest FOMC Watch, Tim Duy asks:

What is the realistically acceptable lower bound for unemployment?

When do officials become very uncomfortable?

The median unemployment rate forecast for the end of this year and next is 3.9 percent. The low of the central tendency of projections is 3.6 percent for 2019. Powell said the longer-run rate of unemployment may be as low as 3.5 percent.

The problem with all of these forecast is that all intents and purposes, a sustained unemployment rate much below 4 percent is basically uncharted territory. The last time the economy sustained such a low level was the late-1960s.

The late-1960s analogy is very interesting. Much has been written of the flat Phillips curve; for more than 20 years inflation concerns have proven overblown. Funny thing though – the Phillips curve was flat for much of the 1960’s as well. Right up until the end of the decade, when inflation quickly emerged – during a sustained period of below 4 percent unemployment. Fiscal stimulus came into play at that time as well.

Note that both Ip and Duy bring up the late 1960s as support to their “inflation may be coming” argument.

Tim Duy illustrates with a version of the chart below.

I have drawn a Phillips Curve for the 1960s. Greg Ip says that “as Michael Feroli of J.P. Morgan notes, this assumption is built on models in which the world behaves in a predictable, linear way. In fact, he says, the world isn’t linear and inflation can change suddenly for unexpected reasons: it “is sluggish and slow-moving, until it isn’t.”

The charts illustrate for the period. When unemployment falls below 4% in a sustained way, inflation picks up.

Since that time, unemployment has reached 4% a few times, but never dropped below that level in a sustained way. Now, however, there are forecasts of unemployment falling below 4% for a sustained period. Will history repeat?

Not necessarily (or even likely). What triggered inflation in the late 1960s was not the below 4% rate of unemployment, but the high and rising rate of NGDP growth, as the next chart indicates.

For the past quarter century, we have experienced relatively stable NGDP growth and no “above target” inflation. In the late 1990s, a positive supply (productivity) shock pulled inflation down. In 2008-09, a strong negative demand shock also pulled inflation down.

NGDP growth has been l ower than the previous trend since then, keeping inflation lower than target. Unemployment has fallen from 10% to 4.1% during this time, with no effect on inflation.

Even if unemployment falls sustainably below 4%, there will be no marked effect on inflation, unless NGDP growth takes off. Does anyone believe that is in the Fed´s plan?

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