The Possible Unemployment Cost of Average Inflation below a Credible - - PDF document

The Possible Unemployment Cost of Average Inflation below a Credible Target Lars E.O. Svensson

Sveriges Riksbank and Stockholm University May 16, 2012

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Issue



Average inflation below target 1996-2011



Average inflation expectations close to target 1996-2011



If inflation expectations stuck at target when average inflation deviates from target, non-vertical long-run Phillips curve?



Higher average unemployment from lower average inflation?



Bias in estimates of sustainable unemployment rate based on historical averages?



Conclusions for the future?

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CPI inflation, CPI inflation expectations, and unemployment 1996-2011

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• 2

2 4 6 8 10 12 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 CPI inflation 1yr inflation expectations 2yr inflation expectations Unemployment

5-year moving averages: CPI inflation expectations close to 2 %, CPI inflation below 2 %

4 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 00 01 02 03 04 05 06 07 08 09 10 11 CPI inflation, 5yr moving average 1yr inflation expectations, 5yr moving average 2yr inflation expectations, 5yr moving average

Before 1996: High CPI inflation expectations (Aragon)

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• 2

2 4 6 8 10 12 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 CPI inflation Inflation next 2 years Inflation next 5 years Unemployment

First few years: Inflation target not credible, tight monetary policy, and high unemployment

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u* u B

*

2 π π = =

e

π

( *)

e

u u π π γ − = − −

Inflation target gradually becomes credible

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* 2 e

π π π = = =

u=u* B C

From 1996: Inflation expectations stuck at 2 %, but monetary policy still tight: Inflation too low, and unemployment too high

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* 2 e

π π = =

u* u C

1 .4 π =

D

Estimate short-run Phillips curve, compute long-run Phillips curve

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Coefficient Estimate

• Std. Error

t-Statistic Prob.

β0

1.835275 0.528245 3.474290 0.0010

β1

1.127351 0.121112 9.308356 0.0000

β2

–0.500917 0.110455 –4.535029 0.0000

β3

–0.283695 0.080984 –3.503117 0.0010

1 2

/ (1 ) γ β β β = − −

2 u π γ γ − = −

3 1 2

/ (1 ) γ β β β = − − −

π − 2 = 4.92 − 0.76 u

Newey-West lag 4, R2 0.84, adj R2 0.83, S.E. 0.51, DW 2.12

1 1 2 2 3

2 ( 2) ( 2)

t t t t t

u π β β π β π β ε

− −

− = + − + − + +

The long-run Phillips curve, 1998Q1-2011Q4

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5 6 7 8 9 10

• 4
• 3
• 2
• 1

1 2 3 Unemployment, percent CPI inflation - 2, percentage points

The unemployment cost of average inflation below a credible target



”Near-rational” inflation expectations?



Akerlof-Dickens-Perry (2000): For average inflation close to zero, a significant fraction of agents disregard inflation; behave as if inflation expectations are zero



Here, for average inflation close to 2 %, a significant fraction of agents disregard deviation from 2 %; behave as if inflation expectations are 2 %



Non-vertical Phillips curve applies for average inflation not too fare from 2 % (± 1 %?)

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The unemployment cost of average inflation below a credible target



1997-2011 average CPI inflation 1.4 %



Average inflation expectations about 2 %



Downward-sloping long-run Phillips curve πt – 2 = 4.92 – 0.76 ut



0.6 p.p. lower inflation gives 0.6/0.76 = 0.8 p.p. higher unemployment on average during 1997-2011



Robustness?

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The unemployment cost of average inflation below a credible target



Point estimate 0.79 p.p.



95 % conf. interval 0.79 ± 0.29 = [0.50 1.08] p.p.



99 % conf. interval 0.79 ± 0.39 = [0.40 1.18] p.p.

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0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6

• .6
• .4
• .2

.0 .2 .4 .6 0.79 + 0.6*(1 - beta_1 - beta_2)/beta_3 beta_0

CPI inflation and unemployment, 1976-2011 Long-run Phillips curve, 1998-2011

14 4 8 12 16 1 2 3 4 5 6 7 8 9 10 11 12 Unemployment,percent CPI inflation, percent 1976 2011Q3 1998Q1 1993Q4

Earlier start, 1997Q1-2011Q4 Flatter, higher unemployment cost

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5 6 7 8 9 10 11 12

• 4
• 3
• 2
• 1

1 2 3 Unemployment, percent CPI inflation - 2, percentage points

Later start, 1999Q1-2011Q4 Not much steeper, not much lower unemployment cost

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5 6 7 8 9 10

• 4
• 3
• 2
• 1

1 2 3 Unemployment, percent CPI inflation - 2, percentage points

Consider CPIXF inflation and gap to Riksbank long-term unemployment

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• 2

2 4 6 8 10 12 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 CPI inflation CPIXF inflation Unemployment Riksbank long-term unemployment

With CPIXF inflation, 1998Q1-2011Q4 Flatter curve, similar unemployment cost

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5 6 7 8 9 10

• 2
• 1.5
• 1
• 0.5

0.5 1 1.5 Unemployment, percent CPIXF inflation - 2, percentage points

With Riksbank unemployment gap, higher cost, possibly overestimate of long-term unemployment

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• 2
• 1

1 2 3

• 4
• 3
• 2
• 1

1 2 3 Unemployment gap, percentage points Inflation - 2, percentage points

Revised Riksbank unemployment gap and long-run Phillips curve, 1998Q1-2011Q4

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• 2
• 1

1 2 3

• 4
• 3
• 2
• 1

1 2 3 Revised unemployment gap, percentage points CPI inflation - 2, percentage points

Revised Riksbank long-term unemployment gap,

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• 2

2 4 6 8 10 12 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 CPI inflation Unemployment Riksbank long-term unemployment Riksbank long-term unemployment, revised

With lagged unemployment Flatter curve, higher unemployment cost

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5 6 7 8 9 10

• 4
• 3
• 2
• 1

1 2 3 Unemployment, percent CPI inflation - 2, percentage points

Other countries



Average inflation in other countries?

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CA average CPI 1996-2011 2.02 UK average RPIX 1995-2003 2.48 UK average CPI 2004-2007 2.01 UK average CPI 2008-2011 3.39 US average core CPI 2000-2011 2.02 US average core PCE 2000-2011 1.86

Canada, 1997Q1-2011Q4 Average inflation on target 2 %

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5 6 7 8 9 10

• 3
• 2
• 1

1 2 3 Unemployment, percent CPI inflation - 2, percentage points

US, 2000Q1-2011Q4 (Fuhrer 2011) Average inflation 2 %

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• 2
• 1

1 2 3 4 5

• 2.5
• 2
• 1.5
• 1
• 0.5

0.5 1 1.5 Unemployment gap, percent Core CPI inflation - 2, p.p.

Conclusions for the future?



Swedish (Prospera) inflation expectations not rational



”Near rational”? Stuck at 2 % for average inflation not too far from 2 %?



Stable inflation expectations of 2 per cent good: Easier to stabilize unemployment without too much variation in inflation



Important to hold average inflation close to 2 per cent



Too low average inflation can entail large real economic costs



Better with price-level targeting, average inflation targeting

• ver a longer period?

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

Government bill (1997/98:40, p. 1): “without prejudice to the objective of price stability, [the Riksbank] should support the objectives of general economic policy with the purpose to achieving sustainable growth and high employment.”

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