Predicting Unpredictable Inflation Rates

Article excerpt

The current economic recovery is nearly six years old, and the annual inflation rate is a meager 3.2 percent -- the lowest level since World War II for an expansion this old. Economists are coming up with all sorts of explanations for the unusual milestone. And gradually many are concluding that inflation has become harder to explain.

The most striking aspect of this milestone is the scramble it is provoking among economists to repair the theory that they use to link unemployment and inflation. The theory, a keystone of economic policy, says that when the unemployment rate falls below a certain flash point, inflation soon accelerates. But the flash point foreseen in theory, 6 percent, was breached months ago, and nothing happened. The unemployment rate went as low as 5.1 percent, and still nothing happened.

"What we have had is a magical belief that we can arrive at an unemployment number that will tell us about inflation," said Richard Rogerson, a University of Minnesota economist, at a conference convened to figure out what had gone wrong with the theory. "We can't." The theoretical concept, known as the natural rate of unemployment, holds that at a certain level, the unemployment rate is just high enough to avoid labor shortages that would push up wages, prompting companies to raise prices to cover the additional labor costs. This equilibrium level, at which the inflation rate neither rises nor falls, has varied from decade to decade, but when the unemployment rate moves below what the Federal Reserve and the economists consider the natural rate, a series of responses develops that usually end in recession. The Federal Reserve raises interest rates to discourage business activity. The unemployment rate then rises as people lose jobs, and the inflation rate falls. But instead of stopping at the natural rate, restoring an equilibrium, the unemployment rate often keeps rising as the economy slows. This sequence in the 1960s and the 1980s, the two other periods since World War II when a recovery has lasted as long as the current one, culminated in recessions. But with the natural rate theory so much in doubt today, the odds of a repeat performance are less. "This is a time to leave everything alone," said Edward S.Hyman, president and chief economist at ISI Group Inc., a Wall Street firm. The trade-offs were much clearer in December 1966, when the 1960s recovery was also three months short of being six years old.The unemployment rate had fallen to 3.8 percent on average for that year, from 4.5 percent in 1965, and as it fell, the annual inflation rate, as measured by the Consumer Price Index, rose to 3.5 percent from less than 2 percent in 1965. The Vietnam War was a big factor, of course, pushing down the civilian unemployment rate and raising wages as working-age people entered the armed forces, leaving labor shortages at home. But with interest rates rising, the economy slowed and recession came in late 1969. Two years later, the unemployment rate, having reversed direction, was 5.9 percent, while the inflation rate had been cut almost in half. The 1980s recovery reached 69 months, the age of the current expansion, in August 1988. Just about then the inflation rate began to edge up from 4.4 percent, while the unemployment rate, true to theory, fell from 6.2 percent on average in 1987 to 5.5 percent in 1988 and 5.3 percent in 1989. In response, the Fed pushed up interest rates and the unemployment rate changed direction, reaching nearly 7 percent during the recession that started in 1990. …