Inflation Dynamics and the Great Recession

IMF Working Papers, June 1, 2011

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Examines inflation dynamics in the United States since 1960, with a particular focus on the Great Recession.
Investigates why Phillips curves estimated over 1960-2007 predict a larger fall in inflation over 2008-2010 than was observed.

Measure of core inflation:
- Use the median CPI inflation rate as the measure of core inflation.
Allowing Phillips curve slope variation:
- Permit the slope of the Phillips curve to change with the level and vairance of inflation.
Hypotheses tested:
- Anchored inflation expectations, distinguishing between "shock-anchored" and "level anchoring".

Phillips curve puzzle:
- Phillips curves estimated over 1960-2007 imply inflation should have fallen by more during 2008-2010 than actually occurred.
- The puzzle is resolved by the two modifications above (median CPI core measure and slope variation).
Inflation expectations:
- Expectations have been fully "shock-anchored" since the 1980s.
- "Level anchoring" has been gradual and partial, but significant.
- It is not clear whether expectations are sufficiently anchored to prevent deflation over the next few years.
Implications for New Keynesian models:
- The Great Recession provides fresh evidence against the New Keynesian Phillips curve with rational expectations.

Subject: Economic theory, Inflation, Labor, Labor share, Output gap, Prices, Production, Supply shocks, Unemployment
Keywords: core CPI, forecasted inflation, Great Recession, Inflation, inflation behavior, inflation expectation, Labor share, median inflation, Output gap, Phillips curve, Supply shocks, Unemployment, WP, XFE inflation