July 21, 2000


Understanding the Recent Behavior of U.S. Inflation, the latest edition of the New York Fed’s Current Issues in Economics and Finance, is enclosed for your review.

Using a standard forecasting model, economists Robert Rich and Donald Rissmiller find that conventional economic forces—in particular, a beneficial supply shock in the form of a large and protracted drop in import prices—can account for the low rates of inflation during the 1990s.

Many analysts view the decline in price inflation through 1999 as evidence of a permanent change in the relationship between inflation and economic growth. They argue that heightened competition among producers and productivity advances made possible by new information technologies have fundamentally altered this relationship.

Rich and Rissmiller, by contrast, conclude that a large and persistent decline in relative import prices has proved especially influential in shaping the behavior of inflation in recent years. They point specifically to a mix of events from the third quarter of 1995 to the first quarter of 1999-- a reduction in oil prices, an appreciation of the dollar and the Asian financial crisis -- during which relative import prices fell at an average annual rate of 6.4 percent.

Rich and Rissmiller make use of a "triangle" model of the Phillips curve to investigate the factors underlying the behavior of inflation in the 1990s. The model takes its name from the specified dependence of the inflation rate on three determinants—inertia, demand, and supply.

The authors test the model to determine whether it can explain the behavior of inflation in the 1990s. They estimate the model over a sample period extending from 1971 to 1991, and using that information they generate inflation forecasts for the 1992-99 period. If the forecasts conform closely to the inflation actually experienced, the authors argue, then the variables included in the model can indeed explain the low inflation rates of the 1990s. If the forecasts deviate conspicuously from the observed path of inflation, then the model’s instability would provide evidence of a fundamental change in the inflation process.

Two factors that are often thought to influence inflation forecasts – wage changes and exchange rate movements – are excluded from the model on the grounds that they show no consistent relationship with inflation movements over short time horizons. The critical factor in the recent performance of the model appears to be the supply component, relative import prices. By adding certain variables to the model one at a time, the authors are able to assess the contribution that each variable makes to the low rates. Rich and Rissmiller find that the incorporation of import prices brings the model predictions closely into line with actual inflation in the latter half of the 1990s.

Contact: Douglas Tillett

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