The Lowdown on U.S. Core Inflation

IMF Blog, July 26, 2016

Source details

Author: Yasser Abdih; Date: July 26, 2016.
Context: After a period when U.S. central bankers worried inflation was too high, the Federal Reserve faces persistently low inflation and aims to boost prices to avoid deflation.
Policy target: The Fed targets a 2 percent inflation rate as one half of its dual mandate of price stability and full employment.
Labor market: The Fed has managed to bring the unemployment rate down to 4.9 percent, yet inflation has remained below its goal.
Core inflation definition: Core inflation strips out volatile food and energy prices and has been persistently below 2 percent (see Chart 1). Core inflation is a better predictor of longer-term price trends because of such volatility.

Main finding: Recent IMF research finds no evidence for a change in the slope of the Phillips curve post-Great Recession; the inverse relationship between inflation and unemployment has not changed.
Explanation: What has changed post-global financial crisis is the nature of economic shocks (for example, weaker global growth) that have been disinflationary and kept inflation low even as the labor market approached full employment.
Correlation effect: These disinflationary shocks have weakened the correlation between unemployment and inflation.
Quantitative responsiveness:
- A one percentage point decline in unemployment only nudges core inflation up by a cumulative 0.1 percentage points over the following two years.
Interpretation: The slope of the Phillips curve is very flat—responsiveness of inflation to changes in unemployment is small even though the slope itself has not structurally changed over the past 20 years or so.

Key drivers keeping core inflation low:
- Falling core prices of goods being exported to the United States from China, Canada, the euro area and Mexico.
- Strengthening of the U.S. dollar.
Transmission:
- These factors have significantly reduced non-oil import price inflation, which in turn has resulted in falling domestic core goods prices (see Chart 2).
- Low imported inflation has also played a role in holding back core services inflation, but to a lesser extent than core goods inflation.
Offsetting domestic factors:
- Declining unemployment and expectations that inflation will ultimately return to its target—bolstered by Fed credibility—have been offsetting factors, particularly for housing services.

Upside scenario (conditions required to push inflation much above 2 percent):
- Depreciation of the U.S. dollar.
- Continued decline in the unemployment rate (which is already quite low).
- A pick-up in house price inflation.
- Rising wages in the health sector (which has a large weight in core inflation).
Benchmark (more conservative) scenario assumptions:
- Constant dollar.
- Constant house price inflation.
Policy implications:
- Under the benchmark scenario, the Fed’s low interest rate policy has been appropriate.
- Future interest rate increases will need to proceed cautiously and gradually to ensure that inflation gets back to the 2 percent target over the next few years.

Source: The Lowdown on U.S. Core Inflation, Yasser Abdih, July 26, 2016.