Inflation should pick up this year
Joseph Gagnon of the Peterson Institute argues the Phillips Curve is not dead, and US inflation is behaving exactly as the Curve would predict. According to Gagnon, the decline in the US unemployment rate is too recent and too small to cause prices to rise noticeably, but inflation will pick up soon, likely...
The modern take on the Phillips Curve is to depict it as the relationship between deviations of unemployment from the natural rate and changes in inflation. When unemployment is below the natural rate, inflation tends to rise, and vice versa.
In the chart below, from the Peterson Institute, the natural rate of unemployment, as estimated by the Congressional Budget Office (CBO). For 2018, the natural rate is estimated to be 4.6%.
From this figure we can see that we are currently below the natural rate. The May 2018 number, not shown below, is 0.8 below the natural rate, at 3.8%. Gagnon argues that this is too small a gap to have an effect on inflation yet.
He then addresses the massive excess of unemployment between 2009–16, and why this excess did not push inflation down significantly. The main reason is most likely that firms and employees are reluctant to accepts cuts in prices and wages; downward wage and price rigidity. According to the author, this is also observed in Japan and Europe.
Based on the premise that downward wage and price rigidity only matter when inflation is low, Gagnon presents two plots of the Phillips Curve, one when the previous year’s inflation was below 3%, and a second when it exceeded 3%. On the horizontal axis is the employment gap. The data is from 1963 to Q1 2018.
Chart from the Peterson Institute. Note: Change in inflation is the four-quarter percent change in personal consumption expenditures (PCE) prices (excluding food and energy) minus the average percent change over the previous three years.
The resulting charts show that with high inflation, in the right panel, the Phillips Curve holds; with a negative employment gap inflation goes down, and with a positive gap inflation goes up. The relationship in the left side panel, with low inflation, is asymmetric; a negative gap does not lead to low inflation. Gagnon argues that the relationship breaks down due to downward wage and price rigidity, as we have seen in 2009 – 16. If this is the case however, then there is no reason to question that a big positive employment gap will eventually lead to a rise in inflation.
He also notes that recent inflation is exactly where this Phillips Curve would predict it to be (see left panel for 2018q1 datapoint)
Gagnon ends with the conclusion that we should not discount the possibility of inflation picking up towards the end of this year;
The May 2018 employment gap is 0.8 percentage point. If the 2018Q2 employment gap turns out to be 0.8 percentage point, the figure suggests that inflation may rise 0.5 to 1 percentage point over the next four quarters, but outcomes both higher and lower than that are possible. Based on the current three-year average rate of core inflation of 1.6 percent, an employment gap of 0.8 percentage point is likely to lead to a core inflation rate of around 2¼ percent in 2019Q2, but outcomes between 1¾ percent and 3 percent cannot be ruled out.