Never mind the flatness, feel the length (of the observed Phillips Curve)

Sorry. It suddenly came to me this morning: a simple (and now blindingly obvious) way to reconcile an apparent contradiction in my own thoughts.

As a lot of people in different countries have noticed, the observed Phillips Curve now looks very flat. Certainly a lot flatter than it did in the past.

And I've been saying of course it looks flat; that's because central banks are now targeting inflation and were doing all sorts of different daft things in the past. The whole point of targeting 2% inflation is to try to make the observed Phillips Curve as flat as possible at 2%. And not just the Phillips Curve; whatever you put on the horizontal axis, if you've got inflation on the vertical axis the central bank is trying to make that observed curve flat. This point is starkest if we assume the central bank has rational expectations and is targeting its internal inflation forecast at 2% given a (say) 2 year targeting horizon. Deviations of inflation from 2% are then the central bank's inflation forecast errors, and if the central bank has rational expectations those forecast errors must have a 0% correlation with any variable or set of variables in the bank's information set 2 years prior.

If the central bank had an NGDP target instead of an inflation target, we might see the observed Phillips Curve having the "wrong" slope. If the bank foresees a period of higher than normal real growth and falling unemployment, it will try to make inflation come in below normal to keep NGDP growth on target.

It's a bit like the standard simultaneous estimation problem in econometrics: If you plot the correlation between P and Q, are you estimating a demand curve or a supply curve or a mix of both? The observed curve could slope either way. Except in this case it's like having a monopoly supplier of apples who adjusts the supply to whatever he thinks will keep the price of apples falling at 2% (the value of money falls at 2% if there's 2% inflation).

The flat observed Phillips Curve is just an artefact of the new monetary policy regime; a statistical illusion.

But at the same time I felt that something structural had indeed changed, and the Phillips Curve really had gotten flatter. The 2008/9 recession really did look like a standard recession caused by a negative shock to Aggregate Demand, and that recession lasted a longish time, and inflation should have fallen below target by more than it did, and certainly not stay the same on average, or even rise in some cases. Inflation targeting works well if "Divine Coincidence" is true; if inflation being above/below target coincides with output and employment being above/below where they should be from the point of view of monetary policy, so the central bank is too loose/tight. Deviations of inflation from target work as a good proxy for monetary disequilibrium, in other words. And Divine Coincidence seems to look a lot worse over the last 10 years than I thought it would look before the recession. Something structural did seem to have changed that made the Phillips Curve flatter, so the same amount of noise shifting the flatter Phillips Curve up and down meant inflation worked as a far worse proxy for monetary disequilibrium. Inflation had become much stickier. And maybe it was inflation targeting itself that had made inflation stickier, destroying its own signal of monetary disequilibrium. So we ought to switch to NGDP targeting instead.

But what evidence could justify my sense that something structural had changed, when a flat observed Phillips Curve is what we would expect?

It's not that the observed Phillips Curve is flat; that is unsurprising. It's that the observed Phillips Curve is flat and long; that is what is surprising.

It's the difference between flat and short, like this:

       xxxxxxx

And flat and long, like this:

x   x   x   x   x   x   x   x   x   x

where each x is an observation - a point in {inflation,unemployment} space.

Either the structural Phillips Curve really has gotten flatter, or else the variance of the natural rate of unemployment is a lot higher now than it used to be, and that does not seem plausible to me.

I feel much better now I've resolved my own cognitive dissonance.

Comments

[marcus nunes]

http://ngdp-advisers.com/2017/06/21/fed-embraces-phillips-curve-everyones-chagrin/?print=pdf

[Majromax]

> else the variance of the natural rate of unemployment is a lot higher now than it used to be, and that does not seem plausible to me.

Maybe it's labour market entry/exit decisions? If we look at the overall employment rate for prime-age workers, I think the Philips Curve holds up a bit better. From FRED, the 25-54 employment rate for the US is 78.5% (April), which is a hair below the minimum of 78.6% set during 2003, in the previous business cycle, even as the unemployment rate flirts with that cycle's economic peak.

[Thaomas]

I like it except this still does not address the fallacy of calling what the Fed actuality has done -- impose a (slightly soft) inflation rate CEILING of 2% with an inflation TARGET of 2% which means that the price level would on average rise by 2% pa. The correct target given the Fed's dual mandate would be a 2% PL trend target conditional on "full employment" of resources. When resources are unemployed policy would raise the PL target and vice versa. You observation is that we are less and less likely ever to observe over-employment and below target PL.

[Scott Sumner]

Good post. The Fed seems to want to use the Phillips Curve to predict inflation. But that makes no sense, as the Fed's dual mandate calls for a countercyclical inflation rate, i.e. and upward sloping Phillips Curve. If the Fed really believes that inflation "naturally" rises during booms and falls during recessions, then why not ignore unemployment and just target inflation. Even a constant (acyclical) inflation rate would be better than procyclical inflation.

[Egmont Kakarot-Handtke]

Laying the bastard Phillips curve to rest
Comment on Nick Rowe on ‘Never mind the flatness, feel the length (of the observed Phillips Curve)’

When you have cognitive dissonances with the Phillips curve it is NOT your fault but rather a sure sigh of mental health. The Phillips curve is misspecified since Samuelson/Solow. To make matters short the elementary version of the correct structural Phillips curve is shown on Wikimedia.#1 The structural Phillips curve consists alone of measurable variables and is therefore identical with what you call the observed Phillips curve.

For the derivation see Sections 5 to 7 of the working paper ‘Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster’.#2

Egmont Kakarot-Handtke

#1 Wikimedia
https://commons.wikimedia.org/wiki/File:AXEC36.png

#2 SSRN
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2130421

[Pete Bias]

Nick, there hasn't been a robust Phillips relation for years. I cranked a bunch of Phillips curves back in 2011 (https://www.researchgate.net/publication/267236507_A_Note_on_the_Textbook_Phillips_Curve)and didn't find anything. I didn't econometric the juices out of it, but regular ol' OLS and plots showed that there is no there there.
Fed (and all CBs) needs to look elsewhere for inflation-predicting help.

Pete Bias

[Nick Rowe]

marcus: it's interesting comparing your last two Phillips Curves graphs. They are both flat (the Fed was implicitly or explicitly targeting inflation in both periods). But the more recent (2007-2017) Phillips Curve is much longer.

Majro: Dunno. Maybe. But I'm always a bit scared of mining different ways of defining the relationship.

Scott: thanks. But if the Short Run Phillips Curve shifts because of supply-side shocks, that might justify the Fed's "Dual Mandate"?

Pete: I think it's useful to ask ourselves the question: suppose the textbook (expectations-augmented Phillips Curve were true, what sort of monetary policy would we need to be able to estimate it using OLS (or something similar)? First, we would need the shocks to monetary policy to be much larger than the shocks to the Phillips Curve itself (and independent of them). Second, if the shocks to monetary policy were "permanent", we would estimate something closer to the Long Run PC, and if they were "temporary" we would estimate something closer to the Short Run PC. But we don't have some sort of idealised experiment like that (thank god).

[Ricardo]

Professor Rowe
The causation of the flatness of the Philips curve, could be the "slack" that may still be verified even though the unemployment rate has decreased, as I try to explain in my post:
https://losinterest.wordpress.com/2017/06/12/stop-employing-unemployment/
I mean, low levels of demand driven inflation may be accompanied by different levels of unemployment rate, because the employment rate is still at low levels, and it's the employment rate and not the unemployment rate that should cause inflation (by the PCurve logic).
Right?
Doctor Sumner, I would very much like to know your opinion about it.
Thank you very much

[Majromax]

> Majro: Dunno. Maybe. But I'm always a bit scared of mining different ways of defining the relationship.

I agree, but before we conclude 'this time is different' I like to first examine 'this time is the same'.

The mechanistic story of the Phillips Curve is that (with a priori constant inflation expectations) a tight labour market requires that, when visited by the Calvo fairy, individual firms raise their wages at a greater-than-expected-inflation rate to attract workers. A posteriori, this results in a higher than expected inflation rate.

The assumption is that a tight labour market means a low unemployment rate and vice versa, but this identity precludes cyclical entry or exit of workers from the labour force. This assumption was obviously violated in the wake of the last recession when workforce participation rates (at prime age) went down; if it's also being violated now that we're in an expansion, then we're not necessarily seeing a weird Phillips curve.

[Pete Bias]

You're right Nick. With targeting, expectations, and thermostats it's tough to empirically find the little doo-dad. And Scott S. is correct in pointing out that the targeting using a Phillips relation somehow assumes everything is demand-driven. Well, some is...

Pete

[Scott Sumner]

Nick, Absolutely. But in that case the Phillips Curve would not be a useful tool to forecast the economy. It only forecasts effectively when there are demand shocks. But demand shocks violate the dual mandate. Policy is supposed to create a world where there are only supply shocks. The Fed can't have it both ways. Implement the dual mandate or use the Phillips curve to forecast. You can't have both.