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VOL. 7, NO. 12 • OCTOBER 2012­­

DALLASFED

Economic
Letter
High Unemployment Points to
Below-Target (But Still Stable) Inflation
by Tyler Atkinson and Evan F. Koenig

Households and
businesses are
generally more
interested in where
prices are headed
than in where they
have been.

T

he Federal Reserve has a
mandate to promote price
stability and full employment.
Generally, “price stability”
is given a forward-looking interpretation. Policy should be conducted so that
expected medium-term (two- to fiveyear) inflation is low and stable or, less
strictly, so that expected inflation beyond
the next few years is low and stable.1
Households and businesses, too, are generally more interested in where prices are
headed than in where they have been.
How best to forecast inflation is controversial. Many analysts have assumed
that changes in inflation depend on the
amount of labor market slack: Inflation
tends to rise when the unemployment
rate is low and to fall when it is high. It
follows that you cannot reduce inflation
without going through a period of higherthan-normal unemployment. Others,
however, believe that slack—at least as
we usually measure it—doesn’t matter:
The best predictor of future inflation is
current inflation.
It appears that both of these views
oversimplify. Neither is a good approximation over the past 15 years—a period
that has been characterized by remarkable stability in long-term inflation
expectations. Our research carries the
implication that should this stability be
maintained, the current high unemploy-

ment rate means that inflation is likely
to run somewhat below 2 percent in the
coming year. It does not mean, however,
that we can expect ongoing declines in
inflation.
To see this, it is helpful to decompose
inflation into three components. The first
is a trend approximated by the inflation
rate that professional, private forecasters
believe will prevail in the longer term. It
excludes the inflation that’s expected over
the coming year, to minimize businesscycle influences. This expected “longforward” inflation is low and steady to the
extent that the private sector has confidence in the Fed’s commitment to longrun price stability. Over the past 15 years,
the long-forward expectation is, in fact,
well-approximated by a constant value
plus a small amount of noise (Chart 1, blue
line), suggesting that the Fed’s price-stability commitment is highly credible.
The second component of inflation
is “cyclical.” It is the difference between
expected long-forward inflation and the
Dallas Fed trimmed mean personal consumption expenditure (PCE) inflation
rate—a weighted average of price changes in which changes on the high and low
extremes are discarded. As its name suggests, the cyclical component of inflation
is sensitive to slack. It tends to be positive
near business-cycle peaks, when the
unemployment rate is low, and negative

Economic Letter
Chart

1

Trimmed Mean PCE Fluctuates Around the Long-Term Trend

Percent change, annualized
6

Expected
long-forward inflation*

5

Trimmed mean
PCE inflation
Cyclical component

4
3
2
1
0

’84

’86

’88

’90

’92

’94

’96

’98

’00

’02

’04

’06

’08

’10

’12

*Survey of Professional Forecasters expectations of CPI inflation over the nine years starting one year after the survey is
taken; 0.3 percentage points is subtracted to adjust for the average difference between CPI and PCE inflation.
NOTE: Gray bars indicate recessions.
SOURCES: Federal Reserve Bank of Dallas; Federal Reserve Bank of Philadelphia; authors’ calculations.

Chart

2

Headline PCE Tends to Converge to Trimmed Mean PCE

Four-quarter percent change
6
5

Headline PCE inflation
Trimmed mean
PCE inflation

4

Transitory component

3
2
1
0
–1

’84

’86

’88

’90

’92

’94

’96

’98

’00

’02

’04

’06

’08

’10

’12

NOTE: Gray bars indicate recessions.
SOURCES: Federal Reserve Bank of Dallas; Bureau of Economic Analysis; authors’ calculations.

following business-cycle troughs, when
the unemployment rate is high (Chart 1).
In practice, the extreme price changes
excluded from the trimmed mean inflation rate tend to be temporary—they are
usually “one off” increases or decreases
that are neither reliably repeated nor
reliably reversed and, hence, are not easily forecast. They make up the third and
final inflation component, the difference
between headline and trimmed mean
PCE inflation, which we accordingly label
“transitory” (Chart 2).

2

In short, inflation has three parts—a
long-run trend that has been constant
since the late 1990s, a cyclical component
that is strongly related to the unemployment rate and can be forecast with some
accuracy, and an unpredictable transitory
component.

Inflation and Monetary Policy
At Federal Open Market Committee
meetings, policymakers adjust the federal funds rate—what banks charge one
another for overnight loans—in response

to changes in the economic outlook.
These meeting-to-meeting decisions
translate, over time, into a path for the
money supply. Growth in the supply
of money, relative to growth in the real
demand for money (determined by real
income growth and changes in payments
practices over which the Fed has no
long-run control), determines the inflation rate. The private sector’s perception
of where Fed policy will eventually take
inflation is captured by a survey of professional forecasters’ expectations of inflation over the nine years starting one year
after the survey is taken. Prior to 1998,
these long-forward inflation expectations
are well-forecast by an equation reflecting a three-fourths weighting of the prior
year’s expected long-forward inflation
and one-fourth weighting of the prior
year’s trimmed mean inflation. Realized
inflation below the long-term trend in
1991–96 pulled down the public’s longforward inflation rate expectation, reflecting policymakers’ increasingly credible
commitment to price stability (as illustrated in Chart 1).
After 1997, the equation that forecasts
long-forward inflation expectations puts
no significant weight on either lagged
expectations or realized inflation. In this
period, the best forecast of what expected
long-forward inflation will be is a constant—specifically, 2.5 percent consumer
price index (CPI) inflation, which translates to 2.2 percent for trimmed mean
PCE inflation, when taking into account
the average gap between the two.

Predictable Cyclical Component
The theory that the level of inflation
is directly related to labor-market slack
was discredited in the 1970s, when inflation exceeded 10 percent despite a high
jobless rate. An alternative theory—that
changes in inflation are systematically
related to slack—then gained currency.
This model fit the data fairly well through
the mid-1980s. During the subsequent
“Great Moderation” period of lower and
less-volatile inflation, however, slack’s
usefulness in inflation forecasting seemed
to disappear (Chart 3), leading some
analysts to conclude that slack holds no
predictive power for inflation.2
Instead of looking for a relationship
between the level of inflation and slack

Economic Letter • Federal Reserve Bank of Dallas • October 2012

Economic Letter
(the 1960s approach) or between the
change in inflation and slack (the 1970s
to mid-1980s approach), we look for a
relationship between slack and deviations of trimmed mean inflation from
expected long-forward inflation (the private sector’s perception of the Fed’s longterm inflation objective).
The deviation of trimmed mean inflation from expected long-forward inflation
(the shading in Chart 1) shows a clear
negative relationship with the four-quarter
lag of the unemployment rate in post-1983
data (Chart 4). When the unemployment
rate is high, trimmed mean inflation tends
to run below long-forward expectations;
conversely, when unemployment is low,
the trimmed mean runs above long-forward expectations.
Statistical analysis shows that besides
the lagged unemployment rate, the
lagged quarterly change in the unemployment rate helps explain the gap between
trimmed mean inflation and expected
long-forward inflation. The lag of the gap
matters too. In other words, the cyclical
component of inflation is sensitive to
both slack and the change in slack, and it
is persistent.
Using the resulting regression equation to forecast trimmed mean inflation
requires making an assumption about
future long-forward inflation expectations.
Given the recent stability of these expectations, it is tempting to assume that they
will equal their post-1997 average value.
A forecast of coming-year trimmed mean
inflation constructed in this way would
have been much more accurate over the
past decade than extrapolating from previous trimmed mean inflation or past longforward inflation expectations.3

Inflation’s Transitory Component
Ultimately, people care about price
changes for all the goods and services
they consume (headline inflation).
Indeed, the price changes that are tossed
out in the calculation of trimmed mean
inflation are probably those most noticed
by consumers. However important inflation’s transitory component may be, it is
unpredictable at a four-quarter horizon.
In particular, it shows no systematic relation to slack (Chart 5) and no persistence
(Chart 6).4 The implication is that the
best way to forecast headline inflation

Chart

3

Idea That Changes in Inflation Are Determined
by Slack Now Discredited

Trimmed mean PCE inflation (four-quarter percent change in four-quarter rate)
1.5

1984:Q1–2012:Q2

1
.5
0
–.5
–1
–1.5
–2

3

4

5
6
7
8
9
Unemployment rate, lagged four quarters (percent)

10

11

NOTE: R 2 = 0.018; standard error = 0.431.
SOURCES: Federal Reserve Bank of Dallas; Bureau of Labor Statistics; authors’ calculations.

Chart

4

Slack Matters for Inflation Deviations from Its Long-Term Trend

Cyclical component* (four-quarter percent change)
1.5

1984:Q1–2012:Q2

1
.5
0
–.5
–1
–1.5
–2

3

4

5
6
7
8
9
Unemployment rate, lagged four quarters (percent)

10

11

*Trimmed mean PCE inflation minus the long-term trend. The long-term trend is the Survey of Professional Forecasters
expectations of CPI inflation over the nine years starting one year after the survey is taken; 0.3 percentage points is
subtracted to adjust for the average difference between CPI and PCE inflation. R 2 = 0.470; standard error = 0.369.
SOURCES: Federal Reserve Bank of Dallas; Bureau of Labor Statistics; Federal Reserve Bank of Philadelphia; authors’
calculations.

is to forecast trimmed mean inflation.
The trimming procedure filters or sifts
out “noisy” components from the inflation data, making it easier to discern the
underlying relationship between inflation
and labor market slack.

Credibility Is Key
Slack matters for future inflation,
but the credibility of the Fed’s commitment to long-term price stability also
matters. Additionally, the effects of slack

are sometimes obscured by transitory
inflation movements. When forecasting
inflation, it is helpful to use private-sector
long-forward inflation expectations to
control for changes in the credibility
of monetary policy and to strip out the
effects of special factors and disruptions
by focusing on trimmed mean rather
than headline inflation.
Near-term inflation’s direct dependence on expected long-forward inflation complicates inflation forecasting.

Economic Letter • Federal Reserve Bank of Dallas • October 2012

3

Economic Letter

Chart

5

Long-forward expectations could adjust
to Fed pronouncements about the future
conduct of policy as well as to near-term
changes in the actual conduct of policy.
Over the past 15 years, expected
long-forward inflation has been “well
anchored”: equal to a constant plus a
small random error. This stability, in
the face of tremendous fluctuations in
economic and financial conditions and
changes to the implementation of policy,
provides encouragement—but no guarantee—that expected long-forward inflation will hold steady over the year ahead.

Transitory Inflation, the Difference Between Headline and
Trimmed Mean Inflation, Shows No Relation to Slack

Transitory component* (four-quarter percent change)
1.5

1984:Q1–2012:Q2

1
.5
0
–.5
–1
–1.5
–2
–2.5

3

4

5
6
7
8
9
Unemployment rate, lagged four quarters (percent)

10

11

*Headline PCE inflation minus trimmed mean PCE inflation. R 2 = 0.045; standard error = 0.679.

Atkinson is a senior research analyst and
Koenig is a vice president and senior policy
advisor in the Research Department at the
Federal Reserve Bank of Dallas.

Notes

SOURCES: Federal Reserve Bank of Dallas; Bureau of Labor Statistics; authors’ calculations.

The Federal Reserve considers a 2 percent inflation rate in
the personal consumption expenditures (PCE) price index
to be consistent with its price-stability mandate. The 2
percent target rate was made explicit in January 2012. PCE
inflation typically runs slightly below the Consumer Price
Index (CPI), partly because PCE accounts for consumers
substituting away from an item as its relative price increases.
2
See “Are Phillips Curves Useful for Forecasting Inflation?”
by Andrew Atkeson and Lee E. Ohanian, Federal Reserve
Bank of Minneapolis Quarterly Review, vol. 25, no.1, 2001,
pp. 2–11.
3
See “Inflation, Slack, and Fed Credibility,” by Evan. F.
Koenig and Tyler Atkinson, Federal Reserve Bank of Dallas
Staff Papers, no. 16, 2012, www.dallasfed.org/assets/
documents/research/staff/staff1201.pdf.
4
Regressions confirm that the four-quarter lag of the gap
between headline and trimmed mean inflation, the gap
between trimmed mean inflation and its long-term trend,
the unemployment rate and the one-quarter change in the
unemployment rate all lack marginal predictive power for
transitory inflation.
1

Chart

6

Transitory Inflation Shows No Persistence at One-Year Horizon

Transitory component* (four-quarter percent change)
1984:Q1–2012:Q2

1.5
1
.5
0
–.5
–1
–1.5
–2
–2.5
–3

–2.5

–2
–1.5
–1
–.5
0
.5
Transitory component,* lagged four quarters (four-quarter rate)

1

1.5

*Headline PCE inflation minus trimmed mean PCE inflation. R 2 = 0.046; standard error = 0.679.
SOURCES: Federal Reserve Bank of Dallas; authors’ calculations.

DALLASFED

Economic Letter

is published by the Federal Reserve Bank of Dallas. The
views expressed are those of the authors and should not
be attributed to the Federal Reserve Bank of Dallas or the
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publication is available on the Dallas Fed website,
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