Using an alternate measure of trend inflation in Phillips curve forecasting models eliminates “missing disinflation”
Some inflation-forecasting models based on the Phillips curve suggest that there should have been more disinflation since the Great Recession than has actually occurred. One way researchers have found to make the disinflation disappear is to remove the long-term unemployed from the overall unemployment measure that is typically used in the models. However, according to Federal Reserve Bank of Cleveland Vice President Todd Clark, the disinflation arises in such models because of the way they account for the long-term trend in inflation. Using a different measure of trend inflation, Clark says the recent path of inflation can be reasonably well explained by an inflation-forecasting model that incorporates the overall unemployment rate.
Clark says one common approach used in inflation-forecasting models is to measure the inflation trend with the recent (past) level of inflation. But he says an alternate approach -- measuring trend inflation with a long-run (10-year average) forecast of inflation from a survey of professional forecasters – has performed better in historical inflation forecasting. Clark notes that the professional forecasters are able to consider a range of information on monetary policy—some outside the scope of simple models.
Incorporating this alternate measure of trend inflation, Clark says his model projects a gradual upward drift in core inflation from mid-2014 through 2016.
Why does the treatment of trend inflation matter in Phillips curve modeling? Clark points to the historical evolution of inflation, which trended sharply higher from the mid-1960s through the early 1980s and lower for about the next 10 years. He says if these shifts, driven by broad shifts in the conduct of monetary policy, are ignored, they can distort estimates of the relationship between inflation and its drivers, such as the state of the business cycle as measured by the unemployment rate. Therefore, says Clark, it is common in Phillips curve modeling to remove some measure of the inflation trend from inflation—that is, to relate inflation minus its trend to the unemployment rate, rather than to relate inflation directly to unemployment.
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Federal Reserve Bank of Cleveland
The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.
The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.
Doug Campbell, email@example.com, 513.455.4479