As in several other industrial countries, inflation in the United States has been low since the mid-1990s despite generally robust economic growth and—especially in recent years—substantial increases in the prices of oil and other primary commodities. A new IMF Working Paper investigates this apparent puzzle by decomposing changes in U.S. inflation into their structural (or long-run) and cyclical components and focusing on the roles that improved monetary policy credibility and globalization have played.
Using quarterly data for 1960–2005 and applying the technique of frequency domain decomposition, the paper first documents two key stylized facts: a secular decline in the long-run component of inflation that began around 1980 and a decline in the size and volatility of the business-cycle component of inflation over the same period (see chart). It then seeks to identify the factors behind these developments using both traditional backward-looking Phillips curve models of inflation and new forward-looking Keynesian Phillips curve models of inflation.
A change in course
After trending downward since 1980, long-run inflation began to increase gradually in 1998.
Data: Haver Analytics and IMF staff estimates.
Traditional Phillips curve models emphasize the role of lagged inflation and the output gap. The paper uses these models to separately explain the long-run and cyclical movements in inflation. It finds that even after taking into account external shocks to capture the effect of imported inflation—proxied by movements in the terms of trade—much of the trend decline is not explained. Traditional models do, however, produce relatively good forecasts for the business-cycle component of inflation. Overall, the results suggest that the decline in inflation since the 1980s is indeed a structural, as opposed to cyclical, phenomenon.
A number of factors might explain why traditional models leave most of the improved inflation performance unexplained. First, they do not allow for forward-looking inflation expectations and, therefore, the possibility that inflation expectations may have been changed by enhanced U.S. monetary policy credibility. Second, measures of the output gap are subject to significant measurement error, especially in view of the apparent structural increase in U.S. productivity growth during the second half of the 1990s.
The new Keynesian Phillips curve models were developed to address some of the shortcomings inherent in traditional models, in particular by allowing for forward-looking inflation expectations and focusing on measures of marginal costs as opposed to the output gap. Although the new models explain the structural decline in inflation somewhat better than traditional models, they, too, fall short of a satisfactory explanation.
The results also suggest that the link between production costs and inflation over the business cycle has weakened in recent years. In particular, using labor’s share of GDP as a proxy for marginal production costs, the study finds that the relationship between inflation and marginal costs breaks down in the late 1990s—around the same time traditional Phillips curve models start to overpredict inflation.
The study finds that allowing for globalization pressures improves the fit of the new models. Indeed, extending the models to allow for imported intermediate goods and equilibrium price markups that vary with the business cycle and the degree of competition improves overall performance. The impact and significance of external variables are evident mostly in the cyclical component, however.
What has caused the secular decline in inflation, and what is implied for the future direction of monetary policy? Despite the absence of satisfactory proxies for monetary policy credibility, the long-run decline in inflation appears to be largely structural and, as such, could reflect improved monetary policy credibility in the United States. The results also suggest that globalization factors influence inflation primarily over the business cycle and are therefore likely to be transitory.
Ravi Balakrishnan and Sam Ouliaris
IMF Western Hemisphere Department
This article is based on IMF Working Paper No. 06/159, “U.S. Inflation Dynamics: What Drives Them over Different Frequencies?” by Ravi Balakrishnan and Sam Ouliaris. Copies are available for $15.00 each from IMF Publication Services. See page 256 for ordering details. The full text is also available on the IMF’s website (www.imf.org).