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The case against price-level targeting.

Abstract As the Fed begins to wrestle with how to stimulate growth in the next economic downturn in an environment of low interest rates, a number of possible changes in its policy framework are being entertained. One in particular that has gained considerable support is price-level targeting, based on the view that this approach would tend to move inflation and nominal interest rates up late in the business cycle, yielding more room for rate cuts when the downturn ensues. We outline the inherent difficulties involved in controlling the level of inflation under the current inflation-targeting regime. We then argue that requiring the Fed to meet the more stringent objective of a price-level target could introduce significantly greater volatility into output growth--potentially worsening economic downturns--than is the case under the current policy framework. We also consider a preferred course of action that adds a bit more flexibility to the current framework, at least for the near to the medium term, and how the Fed might deal with the next recession.

Keywords Fed * Monetary policy framework * Price-level targeting * Inflation targeting * r-Star * Recession

1 Introduction

How the Fed will deal with the next economic downturn has become a topic of considerable interest both within the Fed and among Fed watchers. This interest is not driven by fears of an impending downturn, but rather by a growing realization that when the next recession does occur, the Fed may have less ammunition to deal with it than it has had in the past. The central problem is that the Fed has less scope to cut policy rates than it has had in the past because the real neutral level of the fed funds rate (r*) has fallen substantially over time.

Various solutions have been proposed. One in particular that is gaining some currency both within the Fed and in academic circles is for the FOMC to shift from targeting the inflation rate to targeting the price level. It is argued that this shift would allow the Fed to aim for a higher rate of inflation late in the business cycle, giving it more scope to cut the real fed funds rate into negative territory when expansion ends and downturn ensues.

The main purpose of this note is to outline the case against moving to price-level targeting. The primary argument can be boiled down to the fact that the Fed's control over inflation is very loose to begin with, and requiring it to hit a price-level target is considerably more demanding than just having to hit an inflation target. Doing so could result in a significant increase in the volatility of output or the depth of recessions.

In what follows, we begin by reviewing the central policy challenge facing the Fed in a low r* world. We then touch briefly on the various countercyclical monetary and nonmonetary tools that policymakers will have at their disposal when the next recession hits. Next we drill down in more detail into the price-level targeting solution and review its advantages and drawbacks. We finish by outlining our preferred solution to the Fed's quandary and by considering how the Fed might deal with the next recession.

2 The policy challenge facing the Fed

Over the past seven business cycles, the Fed has cut the Fed funds rate by an average of 6-1/2 percentage points as it has striven to soften and reverse the drop in activity when the economy has gone into recession (Fig. 1). The average drop in rates has been a bit smaller over the past two recessions. Most recently, around the Great Recession, the rate was cut by its maximum extent from 5.25% to just above zero. The declining trend in the magnitude of rate cuts over the decades has been associated with a longer-term downtrend in the real neutral level of the Fed funds rate. Estimates of r* based on a replication of the Holston-Laubach-Williams model have declined from around 4-1/ 2% in the 1960s to 2-1/2% in the 2000s (Fig. 2). (1)

Looking ahead, the Fed's scope to cut rates has been curtailed sharply further by the drop that r* is estimated to have taken during the Great Recession, falling to an average level only l/% over the past decade or so. If inflation returns to the Fed's target of 2% and policy rates overshoot neutral moderately as currently projected, the FOMC will be able to cut rates by just a little over 3 percentage points before it hits the zero bound, roughly half the historical average.

3 Possible solutions

The reduced scope to cut policy rates means other ways to stimulate growth may have to be found. A number of ways have been considered.

1. Fiscal stimulus Countercyclical fiscal policy is a hearty perennial around economic downturns. However, the scope for action over and above

automatic stabilizers (falling taxes and rising transfers as income and employment fall) is declining. US fiscal policy has recently turned procyclical, as tax cuts and spending increases have been implemented with the economic expansion already well advanced. These measures have added to a national debt ratio that was projected by the Congressional Budget Office over a year ago to exceed previous highs for the US by a large margin over the next 25 years (Fig. 3). This path is driven significantly by the heavy demands that a retiring baby boom generation that will be placing on entitlement spending. Articles are already being written about a potential rise in the risk premium on the US Treasury debt. (2)

2. Negative interest rates The scope for stimulus via rate cuts can be increased by breaching the zero bound. Other major economies have had mixed results with this approach--more favorably in Europe, less so in Japan. This solution is viewed more dimly in the US, for at least a couple of reasons. First, there is concern about the strongly negative impact that negative rates would have on money markets, an important conduit for monetary policy. Unable to pass negative rates on to customers, key players would be driven out of business. Second, negative interest rates would likely be politically unpopular with both households and legislators in the US, as they are in Japan. Faced with potentially having to pay fees on their more liquid assets, households could be driven to holding increasing amounts of cash, thereby limiting the scope to reduce bank rates below zero. If banks were reluctant to pass negative rates on to retail depositors, bank margins would be hit, reducing the flow of credit to the economy.

3. Raise the Fed's inflation target The scope for interest rate cuts can also be increased by raising the general level of inflation. If the Fed succeeded in stabilizing inflation and inflation expectations around a higher target of, say, 4%, the level of nominal interest rates would be raised two percentage points above the levels consistent with a 2% target, and there would be correspondingly more room to cut rates. This solution has its problems as well. First, higher inflation carries significant costs--hurting households on relatively fixed nominal incomes, raising the menu costs of changing prices, increasing uncertainty about prices, and making financial planning more difficult, to name a few. (3) Former Fed Chairmen Volcker and Greenspan both defined the Fed's mandate of achieving price stability as holding it to a level that did not significantly affect economic behavior. (4) 2% is generally judged to fit this description, especially given the likelihood that measurement error likely moves measured inflation above actual inflation. (5) Raising the Fed's inflation target would likely be politically unpopular in the US, both with households and in Congress. Doing so would almost certainly require modification of the "price stability" objective laid out in the Federal Reserve Act, which could be difficult. Such considerations led former Fed Chairman Bernanke at the outset of his remarks at a recent Brookings Conference on whether or not the Fed's inflation target should be raised, to proclaim that, "It won't happen, it's not going to happen!" (6)

4. Target nominal GDP growth At the Brookings Conference, Larry Summers proposed adopting a Fed policy to target nominal GDP growth at 5-6%. With potential real growth running at 2%, this would effectively mean targeting inflation at 3-4% and would run into the same problems as raising the inflation target.

5. Target the price level The solution that has received the most positive attention, including from several current and former FOMC members, is to adopt a target to achieve an average rate of inflation of 2% over a particular period of time. This is equivalent to hitting a path for the price level that is defined by that average inflation rate. The reasoning behind this solution is that it would generally induce a rise in inflation late in a business cycle when it might be most useful to do so. Inflation typically falls in recessions and runs below target early in recoveries. Under the current regime, those misses or bygones are not necessarily made up; that is, the Fed lets bygones be bygones as it aims to get inflation back to a 2% level, so that past misses from the Fed's inflation target do not impact current policy decisions. Under a price-level target, however, the Fed would be required to overshoot enough to make up for past undershoots. At the same time, by leaving the 2% inflation objective untouched, this solution may avoid some of the problems associated with raising the Fed's inflation target.

4 The case against price-level targeting

4.1 Dealing with inflation overshoots

One argument against price-level targeting is that in cases when inflation has persistently overshot the 2% target, the Fed might be required to induce a recession to reduce inflation enough to put the price level back on course. This would be politically unpopular. In response to this criticism, former Fed Chairman Bernanke has proposed that price-level targeting be adopted only when Fed policy hits the zero bound. With inflation unlikely to be overshooting in these circumstances, the Fed would be dealing only with reversing inflation undershoots and not overshoots.

4.2 Communication challenges

Under price-level targeting, there could be extended periods when the Fed had to aim for inflation rates that differed significantly from its 2% longer-term objective. This could be confusing to households and make it more challenging to anchor inflation expectations. Let's consider a specific example.

4.3 What if the Fed had adopted inflation targeting in the Great Recession?

How would things look now if the Fed had adopted a price-level target in 2009 when policy hit the zero bound, per Bernanke's proposal? Until fairly recently, the Fed has had monetary policy at full throttle and has slowly and haltingly brought inflation back up toward the 2% target. Based on current expectations the 2% objective should be achieved by sometime later this year. Under conventional inflation targeting, the Fed's job would then be done, and it could continue to focus on getting policy back to neutral and the unemployment rate back eventually to NAIRU. However, as shown in Fig. 4, there have been a lot of bygones (misses to the downside on inflation) over the past decade. Indeed, expressed in level terms (Fig. 5), the Fed has undershot the level of prices defined by an average 2% inflation rate since 2009 by about five percentage points so far. This means the FOMC would have considerable work still to do to achieve its objective under a price-level target. Indeed, it would have to get inflation up to 3% and run it there for another 5 years to close the price-level gap. Trying to convince the public that it really had a 2% inflation target while it aimed to achieve 3% inflation for a period of 5 years would be a hard sell indeed. And that assumes that a 3% inflation rate could be hit and maintained for 5 years. As we will outline next, that in itself is probably an unrealistic assumption.

4.4 How the Fed controls inflation

It is instructive to review just how the Fed goes about achieving its inflation objective. The experience of the past decade indicates that this process is much more difficult than simply stating what its inflation objective is. The way the Fed does eventually get inflation up is by first using its various policy tools (including rates policy, balance sheet policy, and verbal guidance) to move financial conditions (7) in a stimulative direction. Most important here is moving the real fed funds target below the real neutral level of the fed funds rate r* and thereby stimulating the prices of financial assets. Stimulative financial conditions must boost the growth of aggregate demand and employment by enough to move employment above full employment or equivalently the unemployment rate below its full employment level or NAIRU as well as depress other measures of slack in the economy. The tightening of labor and product markets then raises inflation via the negative slope of the Phillips curve and possibly via some boost to inflation expectations. Monetary easing may also depress the dollar and help to boost inflation via higher import prices.

4.5 Key uncertainties in the inflation process

Inflation control as just described is far from an exact undertaking--there are considerable uncertainties surrounding each of the key parameters in this process, including r*, NAIRU, and the slope of the Phillips curve.

Estimates of r* have changed considerably over time and varied widely across different models: current estimates range from +0.1 to + 0.6 (Fig. 6). (8) A recent favorite has been the Holston, Laubach.and Williams model (HLW). The one-standard error band around that estimate ranges from - 0.6 to + 1.6 currently. Thus there is considerable uncertainty about exactly how stimulative Fed policy is at any point in time To put these numbers in context, the current real fed funds rate is + 0.1%, and the standard error band would imply that monetary policy is currently either 70 bp above neutral or 150 bp below neutral--a striking range).

NAIRU, the full employment level of unemployment (or the level at which inflation is assumed to be stable) has varied considerably over time as well (Fig. 7). In the 1980s, it was above 6%; recently it has dipped to an all-time low of just above 4-1/2%. Given the relatively slow response of inflation to the apparent tightening of the labor market, there remains a good deal of uncertainty about just how tight the market is or whether NAIRU might not be significantly below current estimates.

The slope of the Phillips curve has exhibited substantial instability too. The response of core PCE inflation to movements in the unemployment gap in 10-year rolling regressions with a standard Phillips curve model has ranged from -0.7 to zero or slightly positive since the early 1960s (Fig. 8). Recently that slope has been in the vicinity of -0.1 and diminishing (moving toward zero), indicating that the responsiveness of inflation to slack has been low and in decline. Instability of the Phillips curve's slope is one reason inflation models have not done especially well in forecasting inflation. (9)

The key data underlying these Phillips curve results are shown in Fig. 9. The last time the Phillips curve slope was impressively steep was in the later 1960s. The unemployment rate had declined to substantially below NAIRU during 1964-1965 with inflation remaining very subdued. Then in 1966, the inflation jumped, thus recording the opening salvo of the great inflation to follow over the next decade and a half. A growing empirical literature (Fig. 10) has found evidence (based on national data back to the 1960s and state-level data more recently) that the slope of the Phillips curve is nonlinear. That is, inflation tends to jump, although somewhat unpredictably, when the labor market tightens beyond a certain point.

Recent research by the San Francisco Fed as well as by Deutsche Bank's research team has found that a substantial and growing portion of core inflation appears to be insensitive to the business cycle. However, it is also evident that the cyclicality of this portion of inflation changes over time and may be on the rise again. (10)

4.6 Uncertainties in inflation control increase volatility of output

The uncertainties about r*, about NAIRU, and especially about the slope of the Phillips curve, make the Fed's job of inflation control challenging, to say the least. Figure 11 exhibits the importance of these uncertainties. An issue the Fed is no doubt wrestling with is how far to allow the unemployment rate to move below what it thinks is NAIRU in order to achieve its objective of getting inflation back to 2% sustainably. Achieving an additional 5 percentage point increase in the price level, as could have been required under a price-level targeting regime, would be a significantly taller order, requiring an even greater and more sustained move below an uncertain NAIRU. The real challenge arises when it comes time to move the unemployment rate back up to NAIRU to avoid excessive overheating of the labor market and an undesired overshoot of inflation. It is noteworthy, as shown through the history covered in Fig. 11, that the Fed has never been able to achieve a soft landing in this direction. That is, it has never been able to move the unemployment rate back up from significantly below NAIRU without a recession ensuing in the process. In light of potential nonlinearities in the Phillips curve, chances are that the further the unemployment rate is pushed below NAIRU to deal with an inflation (or price level) undershoot, the greater the ensuing inflation overshoot and the greater the recession that will be needed to deal with that overshoot.

5 A preferred solution

It is clear from the discussion above that the Fed has had considerable difficulty hitting its inflation target over time, even as it has allowed bygones to be bygones. Given the imprecision of the Fed's ability to achieve particular inflation outcomes, it stands to reason that asking it to fulfill the more demanding objective of price-level targeting is asking too much. Doing so could very well worsen the degree of inflation overshoots, the volatility of output and the severity of recessions that follow such overshoots. However, there may still be room for the Fed to allow inflation to fluctuate in a somewhat wider range around 2%. Allowing inflation to overshoot to some degree late in expansion phase of the business cycle would provide some additional room to cut rates when the downturn comes. This could be done under the current flexible inflation targeting framework without putting the FOMC in the straightjacket of having to return to a specific price-level path. Allowing inflation to fluctuate in a range around 2% but not requiring it to return to a price-level path (i.e., allowing bygones to be bygones) would make achieving the Fed's inflation objective over time easier and less disruptive to the real economy. The Fed may already be starting to move in this direction. A recent (March 2018) median FOMC projection foresaw, for the first time, a modest overshoot of the inflation target ahead.

6 Dealing with the next recession

When the next downturn does come, we can expect that the Fed will augment its rates-based ammunition with both forward guidance and quantitative easing. Rates-based ammunition could also rise over time as r* begins to return toward historically more normal levels with an eventual recovery of unusually depressed labor productivity and potential GDP growth. (11) Moreover, it seems likely that the next recession will be less severe than the last one. This is partly because regulatory reform has put the financial sector on a considerably safer footing than it had been at the onset of the last recession, and partly because signs of an investment overhang are still relatively benign. It seems likely that the next recession will result from Fed action needed to quell an overheating labor market and economy. Downturns are typically exacerbated when investment in housing, business capital, and/or consumer durables has been excessive. Figure 12 indicates that the ratio of such cyclical spending on durables is still well short of levels reached before the last two recessions, which were caused more by over investment in business capital in 2001 and over investment in housing (in 2007) than by labor market tightness and excessive inflation pressures.

7 Conclusion

To conclude, let us sum up the argument with a medical analogy. Consider a chronic disease that is subject to occasional painful flare-ups. The medication currently used to manage the flare-ups has been losing some of its potency. Several new medications are being developed that could either bolster the effectiveness of the current drug or prove more potent in its place. The problem is that each of these alternatives has negative, potentially painful side effects. These alternatives have not yet been tested in live trials. We do not know how any of them would work in practice on the patient in question: that is, whether they would increase or reduce the overall pain incurred over time. There may be a way to administer the current medication (rate cuts under a flexible 2% inflation target) a bit more flexibly so as to enhance its potency somewhat without incurring significant side effects. Absent a convincing accounting of the potential net pain under alternative medical treatments, this final course of action, supported by inertia, and risk aversion, seems the most likely outcome for now. Finally, there are various alternative nonmedical (i.e., non-rates policy) treatments (such as QE and fiscal stimulus) that have proven useful in the past. Their availability may be subject to uncertain regulatory (Congressional) approval. However, it is likely that the less the potent medical treatment proves to be in quelling severe flare-ups, the more likely these alternative treatments will be employed.


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Peter Hooper joined Deutsche Bank Securities in 1999 as the Chief US Economist. He became the Chief Economist in 2006. Prior to joining Deutsche Bank, he enjoyed a distinguished 26-year career at the Federal Reserve Board in Washington, D.C. While rising to senior levels of the Fed staff, he held numerous positions, including as an economist on the FOMC. He and his top-ranked Economics team produce daily, weekly, and other special publications for Deutsche Bank with a focus on the US and global economic developments and Fed policy; he also comments on the US and global economic and financial developments in the news media. He currently serves as a member and former chairman of the Economic Advisory Committee of the American Bankers Association, a founding member of the US Monetary Policy Forum, an officer of the Forecasters Club of New York, a member of the Economic Club of New York, and a member of the Economic Leadership Council for the University of Michigan. Until recently, he served for 10 years as a member of the Economic Advisory Panel of the Federal Reserve Bank of New York. He earned a BA in Economics (cum laude) from the Princeton University and an MA and Ph.D. in Economics from the University of Michigan. He has published numerous books, journal articles, and reviews on economics and policy analysis.

Peter Hooper (1) (iD)

Published online: 14 June 2018

The author thanks Matthew Luzzetti, Charles Steindel, Laura Desplans, Brett Ryan, Torsten Slok, and Justin Weidner for their helpful comments and suggestions and Sourav Dasgupta ... for excellent research assistance. This note is based on a presentation given at the session "Rethinking the Monetary Policy Framework in a Low Interest Rate Environment" at the NABE Economic Policy Conference, February 26, 2018. It also draws in part on a broader analysis of the Fed's policy framework by Luzzetti et al. (2018).

[mail] Peter Hooper

(1) Deutsche Bank Securities, Inc, New York, NY, USA

(1) The model developed by Holston, Laubach, and Williams can be found in Holston et al., (2016.

(2) See for example, Cashin et al. (2017).

(3) There is some debate about just how costly moderate increases in inflation in the 2-4% range would be. See, for example: Nakamura et al. (2017).

(4) Volcker noted that price stability exists when changes in prices over longer periods "are not a pervasive influence on economic and financial behavior." See Volcker (1983), p. 5. Greenspan said "Price stability is that state in which expected changes in the general price level do not alter business or household decisions." See Greenspan (1996), p. 51.

(5) A little over a decade ago, a BLS staff survey of the literature put the upward bias in the US consumer price inflation at roughly between 0.5 and 1.5%. See Johnson et al. (2006).

(6) See Brookings Institution (2018).

(7) The Fed staff includes a price-level target in its stable of policy rules in the Monetary Policy Report, and that has the fed funds rate still at zero. See Board of Governors of the Federal Reserve System (2018).

(8) The models shown in Fig. 6 include those by Laubach and Williams (2003), Holston et al. (2016), Lubik and Matthes (2015) and Curdia et al. (2015). For more details on this point, see Luzzetti and Weidner (2017a).

(9) The moving slope presented here was estimated in rolling regressions with a variant of the Phillips curve very close to one discussed by Yellen (2015). The instability of that model has been documented by Luzzetti et al. (2018). The problems structural models of inflation have predicting inflation more generally are well documented in Cecchetti et al. (2017) and Faust and Wright (2013).

(10) See Mahedy and Shapiro (2017) and Desplans et al. (2018).

(11) Recent analysis by Weidner et al. (2018) has found that when cyclical inflation is used (extracting acyclical inflation from overall core inflation) in the estimation of r*, the level of r* is raised to several tenths of a percentage point and could be showing some uptrend.

Please Note: Illustration(s) are not available due to copyright restrictions.

Caption: Fig. 1 The Fed has cut rates sharply around recessions. Source Haver Analytics and Deutsche Bank Research

Caption: Fig. 2 Scope to cut rates curtailed by downtrend in r*. Source Deutsche Bank Research

Caption: Fig. 3 Scope for fiscal stimulus diminishing. Source Congressional Budget Office and Haver Analytics

Caption: Fig. 4 Inflation that has run persistently below target. Source Bureau of Economic Analysis, Haver Analytics, and Deutsche Bank Research

Caption: Fig. 5 Price-level undershoot since hitting ZLB. Source Bureau of Economic Analysis, Haver Analytics, and Deutsche Bank Research

Caption: Fig. 6 Considerable uncertainty about r*. Source Luzzetti and Weidner (2017a, b), Deutsche Bank Research

Caption: Fig. 7 Natural rate of unemployment varying over time. Source Haver Analytics and Deutsche Bank Research

Caption: Fig. 8 Slope of the Phillips curve varying over time. Source Deutsche Bank Research

Caption: Fig. 9 Data underlying the Phillips curve. Source Haver Analytics and Deutsche Bank Research

Caption: Fig. 11 How much will unemployment have to fall below NAIRU (and then rise above NAIRU) to achieve price-level target? Source Haver Analytics and Deutsche Bank Research

Caption Fig. 12 The absence of investment overhang reduces recession risk. Source Haver Analytics and Deutsche Bank Research
Fig. 10 Empirical evidence of nonlinearities in Phillips curve

Study                Data            Findings re. slope of
                                     Phillips Curve

Barnes and Olivei    National data   0 when 4.0 < UN < 7.5,
(2003)               1961-2002       otherwise--0.3

Peach et. al.        National data   0 when UN gap less than
(2011)               1960-2010       1.6pp, otherwise -0.17

Kumar and Orrenius   State level     Increases significantly when
(2015)               1982-2013       unemployment moves below

Nalewaik (2016)      National data   Falls to -0.3 as UN gap goes
                     1960-2016       from 0 to -1, falls to -1.0
                                     as UN gap moves from -1 to -2.

Luzzetti and         State level     -0.83 when UR < 4.1
Weidner (2017B)      1988-2016       -0.48 when 4.1 < UR < 6.4
                                     -0.23 when 6.4 < UR
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Date:Jul 1, 2018
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