Will a sharp recession be necessary?
There are currently two prevailing views on managing disinflation, namely: a) to cool off inflation a very sharp recession is necessary and b) long-term inflation expectations exert a strong force on inflation, so that a recession is not necessary.
In this paper, Verbrugge and Zaman provide evidence that contradicts both these views. They use a non-linear Phillips curve specification in which the unemployment gap is decomposed into a transitory component, a moderately persistent component, and a highly persistent component. The moderately persistent component is negatively related to inflation, while the highly persistent one captures low-frequency movements in the business cycle, slowly turning positive during recessions and then negative during expansions. The authors find that inflation is lower when the moderately persistent component turns up during recessions. In contrast, the highly persistent component of the unemployment gap has little association with inflation except when the unemployment rate is far below the natural rate. So a cold labor market is associated with lower inflation, and the labor market has to be very hot to boost inflation to the same degree. Finally, their model incorporates a variable that reflects supply-chain price pressures and is estimated with post-1985 quarterly data. They find:
Despite imposing anchored inflation expectations and a rapid relaxation of supply-chain problems, we find that absent a recession, inflation will be more than 3 percent by the end of 2025. A simple welfare analysis supports a mild recession as preferred to an extended period of elevated inflation, under a typical loss function
The Hard Road to a Soft Landing: Evidence from a (Modestly) Nonlinear Structural Model
Authors: Randal J. Verbrugge, Saeed Zaman
From: Federal Reserve Bank of Cleveland
Managing Disinflations
Authors: Stephen G. Cecchetti, Michael E. Feroli, Peter Hooper, Frederic S. Mishkin, and Kermit L. Schoenholtz
From: Brandeis International Business School, JP Morgan, Deutsche Bank, Columbia University, NYU Stern
Maybe this time is different
In this commentary, Philip Jefferson rebukes the thesis that managing disinflation will inadvertently lead to a sharp recession. He argues:
History is useful, but it can only tell us so much, particularly in situations without historical precedent.
The current situation is different from past episodes in at least four ways. First, the pandemic created unprecedented disruptions to global supply chains. Second, the pandemic is having a long-lasting effect on labor force participation rates. Third, the credibility of the central bank is higher now than it was in the 1960s and 1970s. Fourth and most importantly, unlike in the late 1960s and 1970s, the Federal Reserve is addressing the outbreak in inflation promptly and forcefully to maintain that credibility and to preserve the “well anchored” property of long-term inflation expectations.
Discussion of the Paper “Managing Disinflations” by Stephen G. Cecchetti, Michael E. Feroli, Peter Hooper, Frederic S. Mishkin, and Kermit L. Schoenholtz
By: Philip N. Jefferson – Board of Governors of the Federal Reserve
