Last week, Federal Reserve Board Governor Frederic Mishkin made a presentation on “Inflation Dynamics” before the Federal Reserve’s Annual Macro Conference. It was a late night presentation in San Francisco after markets had closed for week. It received little attention since by the following Monday when markets had reopened, it was “old news.” However, the speech is important. It is a reminder that the Fed is focusing on educating the public more about its direction in monetary policy and is considering adopting formal inflation targets. Mishkin also provides insight into how difficult it may be to bring inflation down further. He also hints at the real dilemma the Fed is likely facing – will the Fed have to adopt an implied or explicit inflation target that is higher than what many believe to be the current implied inflation target.

Mishkin noted many findings from economic research on inflation trends that impact the near-term direction for monetary policy. Mishkin noted that he was speaking only for himself and not necessarily for other FOMC members. However, there is a good chance that other FOMC members think much along the same lines.

Inflation and expectations have trended down

The Fed governor began by noting that the impact of shocks to inflation has declined in recent years compared to the 1970s, the 1980s, and even early 1990s. Changes in inflation from trend inflation currently are not as persistent as in the past. He attributes the rise in inflation persistence during the 1970s and early 1980s to trend inflation becoming “unanchored.” There was no strong belief regarding what inflation should be. This importance of trend inflation being anchored has implications for the Fed’s “communication policy” – which is under reevaluation by the FOMC currently.

A key point from research on inflation is that inflation persistence has fallen so low that the estimated trend for core PCE inflation has been relatively flat since the mid-1990s – edging up over the period but remaining near 2 to 2-1/4 percent.

• Trend inflation has been in the 2 to 2-1/4 percent range for some time.

The changing impact of other factors on inflation - unemployment

How has trend inflation changed relative to some of the traditional cyclical factors or other shocks? The key factors discussed are unemployment, oil prices and import prices.

Traditionally, the unemployment rate has entered analysis on inflation through variations of a Phillips Curve in which inflation depends on the difference between the unemployment rate and the natural rate of unemployment (the unemployment gap) as well as on past values of inflation and also factors such as energy and import prices. The Phillips Curve was conceived originally by the British economist A. W. Phillips. This curve shows a trade-off between lower inflation and higher unemployment.

Mishkin notes that the importance of the unemployment gap has declined since the mid-1980s. He states that the so-called “sacrifice ratio” – the number of years that unemployment has to be 1.0 percentage point greater than its natural rate to reduce the inflation rate 1.0 percentage point – has risen.  It has risen by as much as 40 percent.

“From the point of view of policymakers, this development is a two-edged sword: On the plus side, it implies that an overheating economy will tend to generate a smaller increase in inflation. On the negative side, however, a flatter Phillips curve also implies that a given increase in inflation will be more costly to wring out of the system.”

As seen in the chart below, inflation is much lower relative to the unemployment rate compared to past decades.

• For the Fed to simply rely on higher unemployment to bring down inflation, that process is going to be more time consuming and/or require higher rates of unemployment. While the Fed continues to note tightness in the labor markets as a concern, the Fed also must know that relying on a Phillips Curve approach to ease inflation is not a welcome choice.

Oil prices and inflation trends

Governor Mishkin notes that the U.S. economy is less responsive to some outside shocks on inflation than in the past. Such is the case for oil prices. While the U.S. economy has grown more efficient in its use of oil, the impact of changes in oil prices is less than suggested by improvement in overall energy efficiency.

As seen below, core inflation clearly is less responsive to sharp changes in oil prices than in the past.

This changed relationship is one reason the Fed did not overreact to the spike in oil prices during mid-2006 and also did not over-rely on declining oil prices in late 2006 to bring core inflation down.

• Nonetheless, the recent boost in oil prices will create modest upward pressure on core inflation – delaying the Fed in reaching its inflation target.

Import prices and inflation trends

In contrast, however, research on the impact of import prices on inflation indicates that their impact has not changed over the years. The impact of import prices has not lessened.

This is somewhat disconcerting when realizing the fact that import prices are not helping to bring inflation down now as much as in the recent past.

• Core inflation was most recently below 2 percent only after import prices had been negative to flat. Currently, non-petroleum import prices are running at about a 1-1/2 percent pace – well above rates when core PCE inflation was below 2 percent.

This also means that exchange rate fluctuations have less impact on core inflation.

Inflation expectations

What helps to explain the changes in the relationship between core inflation and these other factors? Mishkin believes a key factor is a change in expectations about inflation. He notes that expectations are now a key feature in “the increasingly popular New Keynesian Phillips curves” based on current period inflation being dependent upon expectations of future inflation and resource utilization.

• Inflation expectations are now a key part of Fed thinking.

The Fed governor is quite explicit about the importance of expectations in his own thinking: "The most important development in monetary economics that I have witnessed over my now-long career has been the recognition that expectations are central to our understanding of the behavior of the aggregate economy. Theory tells us that inflation expectations must be a key driving force behind inflation.”

• Inflation expectations are now running around 2 percent based on two different measures.

• A key outcome regarding expectations is that if expected inflation is anchored, then any shock to inflation will have a smaller impact on expected and trend inflation. This an important thought for some FOMC members.

Mishkin stated, “With expectations of inflation anchored, any given shock to inflation -- whether it is from aggregate demand, energy prices, or the foreign exchange rate -- will have a smaller effect on expected inflation and hence on trend inflation. These shocks will then have a much less persistent effect on actual inflation.”

He noted the sharp rise in oil prices from about $30 per barrel in 2003 to almost $75 per barrel in mid-2006 and that overall inflation did not rise dramatically. This was in sharp contrast to the 1970s during oil price increases.

Policy implications

Governor Mishkin is clear to point out that the empirical research on inflation can be misinterpreted. The sacrifice ratios might be interpreted by some that the cost of bringing inflation down is too high. He sees that as incorrect and that the correct focus is keeping down inflation expectations, then the cost of keeping inflation down is lower. He attributes the Fed achieving its two statutory goals of low inflation and low unemployment to vigilance on “maintaining a low rate of inflation on average.”

“Because the public has become confident that the Fed will do the right thing, expectations now behave in a manner that makes the economy more stable to begin with. If this hypothesis is correct, cyclical movements in interest rates need not be as great as was necessary when expectations were unanchored. However, these favorable circumstances will persist only so long as the monetary authorities continue to ratify the public’s expectations.”

• Mishkin sees an important part of the Fed’s job is to keep inflation expectations low.

Because actual core PCE inflation is running only a little above expected inflation (about 2-1/4 versus 2 percent annualized), Mishkin sees difficulty in bringing inflation down much further without a protracted effort and possibly higher interest rates – although recent oil price increases are delaying this.

“According to the latest reading from the Survey of Professional Forecasters (SPF), long-term inflation expectations are currently around 2 percent, as measured by the PCE price index that the FOMC has emphasized.  ... I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent. This process may take a while in light of the recent rebound in prices for gasoline and other petroleum products.  ... Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. ... [A] substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.”

• The unstated issues include, should the Fed boost its implied target zone of 1 to 2 percent inflation to perhaps 1-3/4 to 2-1/4 percent or something else?

• Additionally, Mishkin strongly appears to be arguing for the Fed to adopt explicit inflation targeting – although he does not come out and say that. An explicit target would help anchor inflation expectations and lower the cost of maintaining the target rate of inflation.

The Bottom Line

Because inflation expectations are still stuck at 2 percent and in light of Mishkin’s view that it is expectations that play the biggest role in determining inflation, the Fed is likely to be on pause for some time in order to bring expectations down and then actual inflation. Additionally, assuming the Fed eventually adopts explicit inflation targets, the Fed may need to consider a range that is higher than the 1 to 2 percent that many assume to be the Fed’s implicit inflation target. Finally, expect a gradual but concerted effort to implement explicit inflation targeting – a good thing for both low inflation and low unemployment.