Since 2013, FOMC participants’ median estimate of the NAIRU has declined from 5.5% to 4.7%. We believe that surprisingly low inflation has been a principal driver of the reductions in their NAIRU estimates over this period. The unexpectedly weak measures of core inflation in March and April this year might put further pressure on their estimates of the NAIRU.
For the most part, estimates of the NAIRU—both at the Fed and elsewhere—have been trending lower since the late 1980s.
• CBO’s estimated (long-term) NAIRU has declined from 6% in 1987 to 4.7% today. • Fed Board staff estimates put the NAIRU at 6.5% in 1987; while we only have median estimates for FOMC participants since 2009, the current median estimate is 4.7%.
Demographic factors are widely acknowledged as one source of this decline. But we believe that inflation surprises have been the dominant source of the FOMC’s reduced NAIRU estimates since 2013. • The inflation surprise during this period has been the failure of inflation to rise as the unemployment rate fell sharply.
• The 0.8-percentage-point decline in the FOMC participants’ median estimate of the NAIRU since 2013 appears to have reflected something more than demographics.
• We see inflation surprises as the dominant source of the FOMC’s reduced NAIRU estimate. When inflation runs persistently below that predicted by their inflation equations—most often some version of an estimated Phillips curve—the Fed Board staff and FOMC participants must assess the causes of that undershoot. There are several, not mutually exclusive, possibilities:
• It could just reflect random noise, and inflation will get back on track shortly.
• It could reflect greater slack in labor and product markets, thus providing a signal that the NAIRU is lower than had previously been estimated.
• And it could reflect other persistent, but transitory, influences on inflation not captured well by the model—such as exchange rate effects or the indirect effects of oil and other commodity prices. In this note, we focus on how inflation surprises are interpreted as signals to change the estimated NAIRU. • Surprisingly low inflation is assumed to signal that there is more labor market slack at a given unemployment rate (U-3) than previously assumed.
• Lowering the estimated NAIRU widens the unemployment gap at a given unemployment rate and therefore provides an explanation for negative inflation surprises.
We identify two periods of inflation surprises. We speculate that the current period of inflation surprises might not be over yet.
• The first is in the mid-1990s through early 2000s.
• The second is the period since the 2007-2009 recession—the period more relevant to current policy considerations.
• Core PCE inflation (12-month rate) edged upward this year from 1.6% to 1.8% in February. The disappointing March inflation number (1.6%) reversed that progress. The April CPI reports suggest that the April PCE report will show a 12-month core inflation rate of 1.5%, and therefore the negative surprise in March will not be reversed. This new negative inflation surprise could, in turn, lead FOMC participants to lower their estimate of the NAIRU as early as in their June 2017 projections.
The extent of labor market slack has been a recurring topic of discussion at nearly every FOMC meeting in recent years. The debate has remained intense as wage and price pressures have been muted despite a considerable decline in the unemployment rate and other measures of slack. Since 2013, the participants’ median estimate of the NAIRU has declined from 5.5% to 4.7%. We believe that surprisingly low inflation has been a principal driver of the reductions in their NAIRU estimates over this period. The unexpectedly weak measures of core inflation in March and April of this year could push some, or even many, participants to lower their NAIRU estimates still further.
Demographics and the NAIRU
It is widely acknowledged that demographic forces have lowered the NAIRU over the past decade or so. Key demographic developments include the aging of the labor force and the sharp decline in the teenage participation rate. This raises the proportion of older worker in the labor force and reduces the percent of
teens in the labor force. These changes in the composition of the labor force lowered the average unemployment rate because older workers have lower than average unemployment rates and teens have higher than average unemployment. A 2015 Chicago Fed paper at the Chicago Fed estimated that demographic forces had lowered the NAIRU by six tenths between 2000 and 2014.1
The Role of Inflation Surprises
In addition to slow-moving demographic developments, inflation surprises appear to be a driving force behind the progressive downward revisions in the estimated NAIRU following the most recent recession.
When inflation is lower than implied by the Phillips curve (which links inflation to labor market slack), a natural explanation is that there may be more slack in the labor market than reflected in the difference between the unemployment rate and the prevailing estimate of the NAIRU. Lowering the estimated NAIRU, in this case, increases the estimate of prevailing slack, better aligning the measure of labor market slack with inflation developments.
Identifying Inflation Surprises
In the recent past, there have been two prominent episodes during which inflation was surprisingly low. The first occurred in the mid-to-late 1990s when the unemployment rate fell below levels that were at that time estimated as the NAIRU. In that period, the considerable supply shock associated with the unanticipated acceleration of productivity can be seen as the principal explanation of the concurrence of declining unemployment and declining inflation. But, interestingly, both the Fed staff and the CBO also lowered their estimate of the NAIRU over this period. So, forecasters parsed some of the surprisingly low inflation as an indication that there was greater labor market slack than they had previously estimated.
The second major episode has been the one following the 2007-2009 recession. Figure 1 depicts the pattern of inflation and the unemployment rate that confronted FOMC participants from the time they began to report their estimates of the NAIRU, in 2009. Despite the decline in the unemployment rate from 10 percent to 4½ percent, wage and price inflation has remained quite muted. And just like in the earlier episode, FOMC participants appear to interpret at least part of the unexpectedly low inflation as a signal that the NAIRU is lower than they had previously estimated.
1 “Changing Labor Force Composition and the Natural Rate of Unemployment,” Chicago Fed Letter, No. 338, 2015 by Daniel Aaronson, Luojia Hu, Arian Seifoddini, Daniel G. Sullivan.
To confirm that participants were in fact consistently making inflation projections that turned out to be too high during the period when their estimates for the NAIRU were falling, we simply look at their forecast errors during this period. In Table 1 we show actual minus the median projection of participants for core PCE inflation out of two to three years. A negative error indicates an overprediction of inflation. Median FOMC projections made in Q4 from 2012 through 2015 consistently overpredict inflation; indeed, there is not a single underprediction.
Inflation Surprises and the NAIRU
FOMC participants began to report their estimate of the unemployment rate in the longer run (aka the NAIRU) in 2009. We show the path of participants’ median estimate of the NAIRU in Figure 2. It has declined from 5.5% to 4.7% since 2013. FOMC participants identified inflation surprise as the major source of this decline:
“Several participants noted that still-subdued wage and price inflation despite the stronger-than-expected momentum in the labor market suggested a lower level of the longer-run normal unemployment rate than they had thought previously.” (March 2015 FOMC Summary of Economic Projections)
Another Step in the Post-Recession Inflation Surprise?
The 12-month core PCE inflation rate had edged up from 1.6% in January 2016 to 1.8% in February 2017. This made the FOMC more confident that inflation was on course to reach 2% by 2019, if not earlier. The unexpected decline in the core PCE inflation in March reversed that progress toward the 2% objective, lowering its 12-month rate back to 1.6%. Moreover, the small rise in core CPI inflation in April suggests that the 12-month core PCE inflation rate may slip further to 1.5% in April, the lowest since the end of 2015.
A few FOMC participants have commented on how they are processing the March-April inflation surprise. President Kaplan was quoted in Bloomberg as saying that he was “very cognizant” of the fact that inflation pressures have been more muted. On the other hand, President George recently said: “core inflation has been trending up. Its unexpected decline in March appears to reflect some one-off factors as opposed to broader disinflationary pressure.” Both these comments came before the April CPI report, which could only have made Kaplan ever more cognizant of more muted inflation. After the CPI report, Evans noted that he was “going to sort of look through that until I get a better reading as to whether or not [inflation has] altered its trajectory.”
It is, of course, too early to say whether the recent decline in the 12-month rate for core CPI inflation through April is just noise from special factors and will be quickly reversed; or whether it will prove a more persistent surprise that will lower the rate of inflation at any level of the unemployment rate going forward—in other words, whether it reflects a lower NAIRU. We expect the 12-month rate of core inflation may linger at 1½% as the June FOMC meeting approaches. At that meeting, we will get updates of
participants’ projections of inflation, unemployment, and the longer-run estimates of the unemployment rate. The June meeting may be too early to elicit any revision in their estimates of the NAIRU. But if the 12- month core PCE remains at 1.5%, or moves even lower leading up to the September meeting, some further downward revision to their estimated NAIRU becomes more likely.