Is Inflation Dead?

Article excerpt

In the past few years the United States has enjoyed the unique economic duet of very low unemployment and declining price inflation. For decades, we have come to associate tight labor markets with accelerating wages and prices. But in 1997, the unemployment rate sank below 5 percent and neither wage nor price inflation became a problem. Have our inflation processes fundamentally changed for the better? Are we in a new era of permanently better economic performance due to new behavior by our citizens? Or are we simply enjoying good luck in the form of positive supply shocks?

The overwhelming majority of research economists had previously estimated that an unemployment rate of about 6 percent was the lowest level that could be sustained. Below the vicinity of 6 percent, employers would compete aggressively for scarce labor by offering wage increases exceeding prevailing norms. The lower the unemployment rate, the greater the percentage wage gain would likely be. As wage increases pushed above existing price inflation and productivity gains, producers would raise prices to cover higher costs. The ensuing wage-price inflation spiral would not be broken until unemployment once more moved above 6 percent, a development typically caused by rising interest rates, as financial markets and the Federal Reserve reacted to the growing inflation problem.

The experience of the late 1980s seemed to confirm the modern validity of this decades-old perspective. The national unemployment rate fell from 6.2 percent in 1987 to 5.5 percent in 1988 and 5.3 percent in 1989; in response, wage increases jumped from 3.1 percent to 3.7 percent and then 4.2 percent. Wholesale price inflation rose from 1.9 percent in 1987 to 2.4 percent in 1988 and then to 3.9 percent in 1989; consumer price inflation jumped from 3.7 percent to 4.1 percent and on to 4.8 percent. Rising prices for imported goods, including oil, contributed significantly to the nation's inflation problems, but most of the blame was placed on excessive tension in domestic labor markets. In other words, lessons learned in the high-inflation 1970s had apparently been reinforced.

At first glance, the experience of recent years seems different. Price inflation remained in check from 1996 through 1998 even though unemployment rates fell further and further below 6 percent. It appeared natural to suspect that the balance point for U.S. labor markets should be recalibrated. Perhaps workers' insecurity was so intensified by the heavily publicized layoffs of the early 1990s that a lower unemployment rate was required before existing employees would demand norm-breaking pay increases.

Unfortunately, a more careful reading of the full inflation story reveals a different conclusion. Nominal wage inflation has been subdued by exceptionally modest price inflation. As can be seen in Figure 1, real, or price-adjusted, wage inflation has been increasing in response to low unemployment, just as in past decades. Price inflation has been held down by a set of "supply shocks," including a strong dollar, falling energy prices, and a cost-reducing regime shift in the health care industry. Moreover, most of these supply shocks are not novel ingredients of the inflation process in the United States. They have been studied and successfully used to understand price behavior for decades.

Inflation is not dead. However, recent supply shocks have shifted wage and price inflation to a lower zone. According to a revalidated, standard model of U.S. inflation, inflation can stay this low only if the unemployment rate rises to between 5.5 and 6 percent over the next year. Otherwise, as supply shocks shift to neutral or worse, tight labor markets will create a traditional inflation problem.

I. The Evolution of the Standard Model of Inflation

The original "Phillips Curve" (of the 1960s) presented a simple, inverse association between wage inflation (w) and the unemployment rate (u). …