Understanding the flattening Phillips curve

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Abstract

Policy-makers have recently noted an apparent flattening of the Phillips curve. The implications of such a change include that a positive output gap would be less inflationary, but the cost of reducing inflation, once established, would increase. This paper’s objective is to review the evidence and possible explanations for the flattening of the Phillips curve in the context of new-Keynesian economic theory. Using data for the United States and Australia, we find that the flattening is evident in the baseline ‘structural’ new-Keynesian Phillips curve. We consider a variety of reasons for this structural flattening, such as data problems, globalisation and alternative definitions of marginal cost, none of which is entirely satisfactory.

Introduction

In recent years, inflation appears to have become less responsive to fluctuations in output and unemployment – that is, the Phillips curve has become ‘flatter’. This has been documented for the United States by Roberts (2006), among others, and a similar phenomenon seems to have occurred in other countries as well (for example, see Beaudry & Doyle, 2000 for Canada).

A decline in the output-inflation trade-off, if it has occurred, would have consequences for monetary policy. As discussed in Bean (2006) and Mishkin (2007b), a benefit is that higher levels of the output gap and lower levels of unemployment would be less inflationary. The problem is that inflation, once established, would be harder to bring down.

While the stylised fact of a flatter Phillips curve has been reasonably well established, the precise reasons for this change are not well understood. Firmer anchoring of inflation expectations is one possibility, advanced by Roberts, 2006, Williams, 2006 and Mishkin (2007b), among others. (This line of reasoning has tended to emphasise the effects of anchoring on inflation persistence rather than the responsiveness of inflation to fluctuations in real activity.) Others, such as Borio and Filardo (2007) and Razin and Binyamini (2007), cite the effects of globalisation.

The purpose of this paper is, therefore, to understand why the Phillips curve seems to have become flatter, using insights from new-Keynesian macroeconomic theory to dissect the linkages between real activity and inflation. Variants of the new-Keynesian framework are extensively used in macroeconomic models at central banks worldwide (for example, at the Riksbank – Adolfson, Laséen, Lindé, & Villani, 2007, and the Bank of Canada – Murchison & Rennison, 2007). According to this perspective, a fruitful way to think about the reduced-form output-inflation nexus is in two stages: first, as a relationship between the output gap and costs; and second, in terms of the linkage between costs (or more precisely, the current and expected future costs) and inflation. A reduction in the overall sensitivity of inflation to output may result from a change in either one of those two stages.

The paper proceeds as follows. Section 2 (briefly) documents the change in the reduced-form Phillips curve in the United States and a small open economy, namely Australia. Section 3 reviews the new-Keynesian inflation model and discusses why a change in the reduced form need not imply a change in firms’ price-setting behaviour. In an effort to determine whether there may also have been a change in the structural inflation equation, in Section 4 we estimate the new-Keynesian Phillips curve, finding that there does appear to have been a reduction in the responsiveness of inflation to marginal costs. Section 5 considers several possible explanations for these findings, none of which is entirely satisfactory.

Section snippets

Reduced-form flattening

Simple scatterplots of inflation and the output gap are striking (Fig. 1). We divide the sample for both countries, with the period after the break displaying a sizeable drop in the volatility of the output gap in each country.1 The moderation

A structural perspective on the flattening issue

The problem with the results above is that, because they come from reduced-form regressions, it is hard to tell whether they represent a change in the true responsiveness of inflation to the output gap, as opposed to a change elsewhere in the economy (for example, in the policy rule, if the central bank decided to respond more aggressively to expected inflation). This is just the Lucas critique (Lucas, 1976). Consequently, we now turn to more structural estimates of the inflation process. We

Has the new-Keynesian Phillips curve become flatter?

In principle, a correctly-specified new-Keynesian Phillips curve model should not be affected by changes elsewhere in the economy, such as in the policy rule, as it is structural.10 Also, as these Phillips curves typically rely on direct measures of marginal costs, they should not be affected by any changes in the sensitivity of marginal costs to real activity. Determining whether the estimated new-Keynesian Phillips curve has changed is therefore essential to

Explaining the flattening phenomenon

The evidence presented in Sections 2 Reduced-form flattening, 4 Has the new-Keynesian Phillips curve become flatter? indicates that something has changed in the way inflation responds to real marginal costs, as measured by labour’s share of income. Also evident is that the relationship between the output gap (when measured as de-trended output) and labour’s share of income, is far from tight. We now review the suspects which have been raised in the literature to see which (if any) can plausibly

Conclusions

It is now 50 years after Phillips first observed the relationship between unemployment and wages, variants of which now occupy a critical position in the intellectual framework underpinning monetary policy. Recently, policy-makers have observed that fluctuations in activity do not appear to be as inflationary as in the past, which is borne out by our estimates of reduced-form Phillips curves. This paper has attempted to summarise some of the common arguments cited regarding why this has

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      Citation Excerpt :

      For the samples that extend from 1960 we observe that the coefficient increases from 0.14 to 0.22 in 2014 and it then declines back to 0.14 for the sample ending in 2020. The finding that the coefficient of the output gap increased from 1979 to 2014 contradicts the generally found result from the new Keynesian models (e.g. Kuttner and Robinson (2010) and Occhino (2019)). In relation to the sample between 1960 1969, the output gap coefficient is 0.22, not too far from the rest of the samples.

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    This research was initiated while Ken Kuttner was a visiting scholar at the Reserve Bank of Australia. Allen Tran provided exceptional research assistance. We have received useful comments from Jeremy Rudd and Charles Steindel. The views expressed herein are those of the authors and not necessarily the Reserve Bank of Australia. Any errors are our own.

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