NEW YORK—The Federal Reserve Bank of New York today released How Does Slack Influence Inflation?, the latest article in its series Current Issues in Economics and Finance.
In a statistical analysis, authors Richard Peach, Robert Rich and Anna Cororaton find support for the hypothesis that the level of resource utilization in an economy must cross certain thresholds before it will have a significant effect on inflation.
According to the authors, economic theory holds that when firms use labor and capital intensively, their production costs tend to rise, and they have more latitude to pass these cost increases through to their customers in the form of higher product prices. However, when the economy operates with slack, firms' production costs grow more slowly, and firms have less latitude to raise prices. Thus, these relationships suggest that policymakers can use measures of resource utilization to help predict future changes in the rate of inflation.
As the authors explain, empirical analysis of U.S. data bears out the linkage between resource utilization and inflation during the period from World War II to the mid-1980s. However, from that point through the mid-2000s, the significance of the relationship appears to break down. Using the unemployment rate as a proxy for overall resource utilization in the economy, Peach, Rich and Cororaton observe that in this second period, the unemployment rate had little power to predict inflation.
To explain this changed relationship, researchers have advanced the hypothesis that the unemployment rate will help predict future inflation only when it is above or below certain critical values, or "thresholds." In this study, Peach, Rich and Cororaton assess whether the threshold hypothesis holds when more current data are added to the analysis. Their model relates the rate of inflation to a measure of labor market slack—specifically, the "unemployment gap," or the difference between the actual unemployment rate and the non-accelerating inflation rate of unemployment.
The authors find that the impact of the unemployment gap on inflation does indeed differ markedly within and outside the estimated thresholds. Moreover, the authors' model generally tracks the slowing of core inflation over the 2008-10 period. These findings, the authors suggest, "provide general support for the notion that the unemployment gap must be below or above certain threshold values before it can help to predict movements in inflation and thereby serve as a useful guide for monetary policymakers."
Richard Peach is a senior vice president, Robert Rich an assistant vice president, and Anna Cororaton an assistant economist in the Macroeconomic and Monetary Studies Function of the Federal Reserve Bank of New York.