Why has inflation in the United States been so stable since the 1990s?

• In this article, we study the causes of the stability of US inflation over the business cycle since the 1990s.
• We conclude that it is mainly due to a reduced sensitivity of firms pricing decisions to their cost pressures.
• Ignoring this observation could impair the ability of monetary policy to steer inflation toward its objective.

Inflation has become insensitive to the business cycle

• US inflation used to rise during economic booms, as businesses charged higher prices to cope with increases in wages and other costs.
• When the economy cooled and joblessness rose, inflation declined.
• Since then, US inflation has remained remarkably stable, even though economic activity and unemployment have continued to fluctuate.
• For example, shortly after the Great Recession, the unemployment rate reached 10%, but inflation barely dipped below 1%, leading many economists to look for the missing deflation (e.g.
• More recently, with unemployment below 5% for almost four years and inflation persistently under 2%, attention turned to explaining what is holding inflation back (e.g.

Is the stability of US inflation due to changes in the functioning of labour markets, a flatter Phillips curve, or improved monetary policy?

• What explains the emergence of this disconnect between inflation and unemployment? Economists have explored three main classes of explanations.
  1. The functioning of labour markets has changed in the last three decades, making unemployment a poorer indicator of both the degree of resource under-utilisation in the economy (sometimes referred to as “economic slack”) and of the cost pressures faced by firms.
  2. Firms’ pricing decisions have become less sensitive to these cost pressures. In economic jargon, this phenomenon corresponds to a flattening of the so-called Phillips curve – a relationship capturing the fact that a boost in production typically pushes up the cost of production inputs, and thus leads to higher output prices.
  3. Policy has become more successful in stabilising inflation (McLeay and Tenreyro, 2019).
  • In this article, we discuss the relative merit of these three explanations based on evidence from a combination of state-of-the-art macro-econometric techniques.
  • [2] The bulk of this empirical evidence points towards the second explanation a flatter Phillips curve due to the reduced sensitivity of firms pricing decisions to their cost pressures as the main driver of inflation stability.
  • In terms of policy, this finding implies that inflation has become harder to steer, unless monetary authorities systematically take into account the flattening of the Phillips curve.

Our findings

• In contrast, inflation has become insensitive to business cycle fluctuations.
• This observation rules out changes in the functioning of labour markets as a leading explanation for the inflation-business cycle disconnect.
• This leaves us with two possible explanations on the table, a flatter Phillips curve and improved monetary policy.
• Monetary policy can limit their impact on inflation by leaning against the wind, that is, by counteracting their effects on economic activity as well.
• Therefore, if improved monetary policy is behind inflation stability, these demand shocks should have minor effects both on inflation and unemployment after 1990.
• Figure 1 plots the responses of unemployment and inflation to a demand shock before and after 1990.
• [3] The last two panels show that the response of inflation to demand shocks has indeed become significantly more muted since 1990.
• If this analysis is correct, the fact that economic activity collapsed while inflation did not fall substantially suggests that the Phillips curve must be flat.
• This flattening of the Phillips curve is also what we find by estimating the New York Fed DSGE model before and after 1990.

What’s next in terms of research in this area?

• Investigating the deeper forces behind the flattening in the Phillips Curve is outside the scope of our analysis and it is still an open question in the specialised literature.
• The most prominent hypothesis attributes the reduced responsiveness of prices to cost pressures to the increased relevance of global supply chains, heightened international competition, and other effects of globalisation (e.g.
• Understanding this further is of first order importance for central banks, and it is expected to be the focus of intensive research efforts going forward.

References