Abstract: By most estimates, the U.S. unemployment rate is currently below its The implication is the economy is operating at an unsustainably high level of resource utilization. Capacity levels are being strained, tending to put upward pressure on wages and prices. In anticipation of these rising inflationary pressures, the Federal Reserve has finned monetary policy several times over the past year. In recent research, I have examined the natural rate framework in detail, presenting new estimates of the natural rate of unemployment and discussing monetary policy implications (Weiner 1993, 1994). I believe it is fair to say that a majority of mainstream macroeconomists are comfortable with the natural rate framework, in part because it has tracked inflation successfully over the past 35 years. All four inflationary episodes since the early 1960s have been marked by the actual unemployment rate falling below the natural unemployment rate. Moreover, there have been no false signals. Not once has the actual unemployment rate fallen below the natural rate without inflation eventually accelerating.(1) Despite its excellent record in tracking inflation turning points, the natural rate framework has not been without critics. In the past year, nonbelievers have advanced a number of arguments for why mounting inflationary pressures should not be a concern at this time. It is useful, therefore, to consider these arguments and offer some counterarguments. Current inflation is well behaved The most frequently heard argument is that prospective inflation is not a concern because current inflation is well-behaved. The shortcoming of this argument is that it ignores the inertia in the inflation process. Historically, only once has a sustained increase in inflation begun precisely at the same time that unemployment has fallen below its natural rate.(2) It has been more common for inflation to follow with a lag, sometimes up to several quarters long. Such lags are to be expected, given the amount of inertia in U.S. wages and prices. Thus, the lack of an unambiguous rise in consumer inflation to date does not imply the economy has not yet reached its natural rate. Claims that the Federal Reserve is fighting a phantom inflation have been fueled not only by the absence of a clear rise in inflation but also by the modest deceleration of inflation at the end of last year. But this view also does not stand up to close examination. Several times in the past, inflation initially declined a bit even as the economy passed through its natural rate. This is not surprising. Given the lags, a positive unemployment gap (actual unemployment rate above the natural rate) three or four quarters ago could still be exerting slight downward pressure on inflation today. In the same way, a negative unemployment gap (actual unemployment rate below the natural rate) today can be expected to lead to an increase in inflation tomorrow. In fact, this pattern has occurred several times in the past. Chart 1 shows the four inflationary episodes of the last 35 years and the current situation. The first quarter shown in each episode is when the unemployment gap first became negative. Thereafter, the unemployment gap and inflation are tracked until inflation stopped rising. In three of the four inflationary episodes, inflation initially declined somewhat after the unemployment gap became negative--specifically, in the 1964-70 episode, the 1972-75 episode, and the 1977-80 episode. The current episode, beginning in mid-1994, is thus not atypical. It is simply too early to expect much of a rise in inflation. Moreover, with first quarter data now available, we know that inflation has turned up since the end of last year. Heightened globalization Another frequently heard challenge to the natural rate framework is that heightened globalization--the increased openness of the U.S. economy--has altered historical relationships. …
Publication Year: 1995
Publication Date: 1995-04-01
Language: en
Type: article
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Cited By Count: 4
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