As I mentioned above, if we work hard enough we can find a Phillips curve relationship. For example, if we think there is an episode where monetary factors were important, then we should see the Phillips curve over that period, as monetary shocks tend to move inflation and the unemployment rate in opposite directions in the short run. So, consider the period of time between fourth quarter 1980 and third quarter 1982, when Paul Volcker was using monetary policy to bring the rate of inflation down. For that period, we get:
One of the more puzzling aspects of New Keynesian economics is the enthusiasm for bringing the Phillips curve back into the mainstream. After the 1970s, the Phillips curve had a low profile in academic work, but has had a resurgence since the 1990s in the form of the "New Keynesian Phillips curve." If you know how the discourse has evolved in central banks over time, you'll also know that, whatever was going on in the economics journals, central bankers never lost their affection for the Phillips curve. That's part of what makes New Keynesian economics attractive for them.
In part, the Phillips curve is used in central banks for forecasting. Indeed, that tendency is not confined to central banks, as the note attached to the CBO natural rate series in FRED indicates:
The short-term natural rate is used to gauge the amount of current and projected slack in labor markets, which is a key input into CBO's projections of inflation.My best guess is that the Federal Reserve Board's inflation forecasts, which seem to rely on the FRB/US model, or other mechanisms kept secret from those of us on the outside, put significant weight on output gap measures. You can see that in published Fed inflation forecasts, which typically show inflation well below the 2% inflation target in the immediate future, and reverting to 2% over a period of three years or more, because they view the output gap as high and falling.
So, policymakers seem to think that the output gap, say as measured by the deviation of the unemployment rate from the natural rate, is useful in forecasting inflation. But to comment on usefulness, we have to run a horse race. So, let's set the bar really low. Suppose I am a very lazy forecaster, and my forecast for next quarter's inflation rate is this quarter's inflation rate. If the output gap is useful in predicting inflation, then if we deliver output gap measures to our lazy forecaster, he or she should be able to make a better forecast. One indication of what the lazy forecaster has to gain is that, if he or she ignores the output gap measure, he or she should make forecast errors that are correlated with the output gap. If the output gap is high, he or she will tend to miss on the low side, and vice versa if the output gap is low. So, let's check that out.Atkeson and Ohanian told us long ago.
Perhaps more embarrassing for Phillips curve enthusiasts is what is going on in the recent U.S. data. The last 9 quarters of data (2011Q3 to 2013Q3) looks like this:
Whether central bankers are embarrassed is not clear. They certainly are puzzled, though, as this WSJ article indicates:
Mr. Bullard has also underscored that even as the economy’s outlook has improved, inflation continued to undershoot the Fed’s 2% target, and central bankers don’t have a good explanation for why this is happening.
Conclusion: If I want to find a Phillips curve relationship in the data, then through some process of specification searches, Bayesian estimation with alternative priors, or whatever, I will be able to find it. If I'm looking hard for the Virgin Mary, I can find her in a grilled cheese sandwich. But Phillips curve thinking isn't helping monetary policy right now. It just makes people puzzled.
So, my attempt in what follows is to reduce puzzlement. While the Phillips curve can be hard to find in the data, the Fisher relation is not. From the same data set that produced the first chart, we get:
So, if we suppose that the real rate of interest is constant in the long run, we might fit a straight line to the points in the chart above (as I have done), and then think of the deviations from that straight line as short-run deviations from a "natural real rate of interest." One factor that may cause the real interest rate to fluctuate in the short run is monetary policy. In particular, some models of the short-run nonneutrality of money tell us, and central bankers certainly have told us for a long time, that in the short run monetary tightening - an increase in the nominal interest rate - makes the real rate of interest go up and the inflation rate go down. That's a feature of New Keynesian models, and it also comes out of other traditions. For example, segmented markets models exhibit a liquidity effect (real interest rate goes down in response to monetary stimulus in the short run), one example of which is this Alvarez/Atkeson/Kehoe model.
You can see the liquidity effect in the data from the Volcker disinflation period.
Here's a heuristic approach to this. This, I think, is roughly what you would get if you took some of the models I have been working with, and put in aggregate shocks and short-run liquidity effects. First, suppose that the long-run real rate of interest is a constant. Then, in the next chart, LRFR is the long-run Fisher relation.
Next notice, in the Fisher relation data chart, that a nonlinear long-run Fisher relation would fit better than a straight line. That is, at low rates inflation, the real interest rate tends to be low. I get an effect like that in some of my work, and it comes essentially from an effect on the liquidity premium associated with interest-bearing safe assets. So, in the next chart, the curve LRFR1 denotes the long-run Fisher relation, which is concave.
Further, there are other forces in play currently that will tend to move point E to the left if the nominal interest rate stays at zero. The destruction of private sources of collateral and the shaky state of sovereign governments in parts of the world gave U.S. government debt a large liquidity premium - i.e. those things reduced real interest rates. As those effects go away over time, real rates of return will rise, shifting up the long-run Fisher relation, and reducing inflation if the Fed keeps the nominal interest rate at the zero lower bound.
If the Fed actually wants to increase the inflation rate over the medium term, the short-term nominal interest rate has to go up. We need to be at a point like D. There used to be a worry (maybe still is) of "turning into Japan." I think what people meant when they said that, is that low inflation, or deflation, was a causal factor in Japan's poor average economic performance over the last 20 years. In fact, I think that "turning into Japan" means getting into a state where the central bank sees poor real economic performance as something it can cure with low nominal interest rates. Low nominal interest rates ultimately produce low inflation, and as long as economic stagnation persists (for reasons that have nothing to do with monetary policy), the central bank persists in keeping nominal interest rates low, and inflation continues to be low. Thus, we associate stagnation with low inflation, or deflation.
So, here's the policy advice for our friends on the FOMC. Continuing to engage in short-run monetary stimulus, through QE, will have little or no effect on real economic activity. The short run stimulative effects of monetary policy have pretty much played themselves out, and the real effects get smaller the more you do it. If there's any tendency for inflation to change over time, it's in a negative direction, as long as the Fed keeps the interest rate on reserves at 0.25%. Forget about forward guidance. You've pretty much blown that, by moving from "extended period" language, to calendar dates, to thresholds, and then effectively back to extended periods. That's cheap talk, and everyone sees it that way. So, as long as the interest rate on reserves stays at 0.25%, there are essentially no benefits in terms of more real economic activity. But you're losing by falling short of the 2% inflation target, which apparently you think is important. And you'll keep losing. So, what you should do is Volcker in reverse, except you don't have to move the inflation rate up much. For good measure, do one short, large QE intervention. Then, either simultaneously or shortly after, increase the policy rate. Under current conditions, the overnight nominal rate does not have to go up much to get 2% inflation over the medium term. Otherwise, you're just stuck in a rut, which would be too bad.