What's Down with Inflation

What's Down with Inflation?

Tim Mahedy and Adam Shapiro

This new research is published from San Francisco FED Team. You can download full research from this link.

Everything is ok, yes?

The labor market has fully recovered, the dollar has appreciated, and oil prices are no longer declining as rapidly, Chair Janet Yellen recently said that the reason why inflation remains low is a “mystery” (Yellen 2017).

What is the procyclical and acyclical inflation ?

We distinguish between categories where inflation has historically exhibited a procyclical relationship with overall economic conditions, moving in tandem with the economic cycle, and those categories where inflation has been acyclical, that is, driven by category-specific developments that are independent of the state of the overall economy.

We show that procyclical inflation has steadily returned to its pre-recession level, in line with improvements in economic conditions and a tightening labor market. However, acyclical inflation has been persistently low, suggesting that idiosyncratic factors have helped hold down PCE inflation.

The well-known Phillips curve implies that inflation tends to move in the same direction as the overall economy. During good economic times, when the unemployment rate is low, high demand relative to supply causes businesses to raise prices. During recessions, when the unemployment rate is high and there is excess supply, businesses are less apt to raise prices, causing inflation to decline.

We drill down to the categorical level to assess whether inflation for individual categories responds to changes in overall economic activity. This allows us to examine whether some categories’ prices are more sensitive to business cycle conditions than others. 

For each category we estimate a basic Phillips curve relationship between the unemployment gap—the gap between the national unemployment rate and its long-term or natural rate—and changes in prices for that category, using data from 1985 through 2007.

If the sector’s inflation rate shows a negative and statistically significant relationship with the unemployment gap, we categorize the sector as procyclical. If the sector does not satisfy this criterion, we categorize the sector as acyclical.

We attribute much of this persistent weakness in core PCE inflation to cuts in the growth of Medicare payments, which have translated into slower inflation throughout the health-care sector.

Dr. Engin YILMAZ

29.11.2017

Ankara