Paul Krugman pulls together three charts to illustrate the link between high unemployment and disinflation in two major disinflationary episodes, 1974-1977 (Series 1 in chart below) and 1980-1986 (Series 2). He then tracks the pattern of the current cycle (Series 3), which suggests that the combination of high unemployment and past disinflationary responses to such unemployment is very likely deflationary. Krugman asks:
How can you look at this record and not conclude that deflation is a very real risk? I have no idea where the complacency of many at the Fed comes from.
An explanation for the Fed’s complacency can be found by plotting all three episodes on the same chart:
I believe when monetary policymakers look at this chart, they ask a different question: Why has the disinflationary response been so muted in this cycle? It would have been reasonable to conclude that unemployment rates at this magnitude should have long ago pushed the US economy into deflationary territory. What is the Fed’s explanation for the relatively tame disinflation? Krugman already has the answer:
All of this was to be understood in terms of a Phillips curve in which actual inflation at any point in time depends both on the unemployment rate and on expected inflation….
Fed officials will say that inflation expectations are currently well anchored. Indeed, the early 1980’s experienced a period of rapid disinflationary expectations:
Note that expectations by this measure are stable. What about financial market expectations? The difference between 5 year Treasuries and 5 year TIPS fell slightly in recent months, but nothing like the clear taste of deflationary expectations at the end of 2008:
But are stable inflation expectations written in stone? Krugman concludes the above sentence with:
…and expected inflation gradually adjusts in the light of experience.
The implication is that the Fed should not get too complacent as persistently high unemployment will eventually erode those expectations.
Now – just thinking out loud – suppose downward rigidity of nominal wages, with workers unwilling to accept nominal wages declines. Does this support positive – albeit low – inflation expectations? Which thus prevents deflationary expectations from forming…which is good, but prevents the Fed from further action despite high unemployment rates? And the lack of action that increases structural unemployment, ensuring NAIRU increases? Something else to chew on…
Originally published at Tim Duy’s Fed Watch and reproduced here with the author’s permission.