Do We Need Recession to Cool Inflation?

By Fisher Investments Editorial Staff ? 3/1/2023

One Fed paper says yes, but the support doesn't seem so strong.

Last Friday, a paper presented at a high-profile monetary policy forum in New York found the Fed needs to induce a recession via rate hikes in order to tame inflation. The paper, written by a group of economists for the University of Chicago's annual get-together, comes as fears grow that the economy is doing too well?running hot?showing the Fed needs to act much more aggressively. But a look at the paper shows why investors shouldn't take those views to the bank.

Here is how the paper put it: "... there is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession ... simulations of our baseline model suggest that the Fed will need to tighten policy significantly further to achieve its inflation objective by the end of 2025."[i] Coverage then pronounced game over. One headline declared, "Fed needs a recession to win inflation fight, study shows."[ii] Another posited that, "Fed's rate hikes likely to cause a recession, research says."[iii]

But before you nod along, consider the data and methodology. While it uses disinflationary episodes in the US since the 1950s, for Canada, Germany and the UK?comprising 10 of the 17 periods sampled?it looks only at the 1970s onward, skewing the dataset heavily towards the mid-1970s and early-1980s. It also omits the mid-1990s' and mid-2010s' disinflations. Perhaps they weren't big enough. But that means the data basically feature one global episode of hot prices. Notably, Japan wasn't included, either, "due to the exceptionally modest fluctuations in the unemployment rate." Which highlights what drives the model: "measures of labor market slack." It relies on the supposed relationship between unemployment and inflation?the Phillips curve?and another theoretical construct called the output gap. But both are suspect.

The Phillips curve assumes inflation is tied inexorably to employment. It argues that low unemployment signals a high-pressure economy, which spirals prices higher. Workers empowered by scarcity demand higher wages, which companies pass on to consumers?lather, rinse, repeat. So a central banker wanting to slow prices would have to drive up unemployment. That may sound logical, but it hasn't worked out that way very often in practice.

Consider the 1970s, when high inflation coincided with high and rising unemployment. Or, more recently, the 2010s' low-unemployment and low-inflation expansion. There isn't a relationship because inflation is a monetary phenomenon?too much money chasing too few goods and services. Labor markets may play into this. But they aren't essential to it, in our view. As Milton Friedman taught years and years ago, wages generally follow inflation?they usually don't lead it.

The same goes for the output gap, which is based on estimates of potential GDP?if all the economy's capital and labor were fully employed. If the economy is growing below potential, supposedly, no inflation. If above, inflation. Problem is, like the Phillips curve, it doesn't work. The Congressional Budget Office (CBO) puts out among the most widely cited output-gap measures, but even these are just educated guesses. No one really knows how accurate the models used are in real time. The CBO's have given many false signals since the 1970s. Above-potential readings in the early-2000s and 2005 - 2008 didn't bring hot inflation. And perhaps more damningly, except for one quarter being 0.5% over potential in Q4 2021, GDP has been under estimated potential output throughout the current inflationary episode.[iv]

We see little evidence increasing the unemployment rate?or output gap?brings down inflation. Hence, the idea that a recession is necessary to cool prices now seems off to us. Furthermore, consider: The chief driver of slowing inflation, in our view, is cooling money supply growth. And that has happened. M2 growth has already slowed globally, to the point of turning negative in America. The Divisia M4, the broadest measure of money supply, is flattish. And, beyond money, consider: Myriad other input prices?from oil to grains to shipping and more?are well off their highs. As these feed through the economy, it is likely prices will cool?regardless of what the Fed does. Maybe the quote we shared earlier is a hint at that outcome. After all, it said, "there is no post-1950 precedent for a sizable central-bank-induced disinflation." (Emphasis ours.)

Of course, this isn't to say the Fed won't induce recession. We question the central bank's ability to do so via traditional rate hikes right now, given a flood of deposits renders interbank borrowing?its chief channel to influence credit and inflation?rather moot. But maybe the Fed and other central banks take more radical action, like reimposing reserve requirements suddenly and drastically. That could freeze credit. But the idea the Fed must force contraction to cool prices seems to commit the same error central bankers made in 2020?overreacting.

So will the Fed keep hiking until there is a downturn? Who knows. It has screwed up before. But necessary and automatic? Seems like an overstatement.

1. How can the Federal Reserve enable a recession? Why do economists from the University of Chicago argue that the Federal Reserve needs to enale a recession in order to reduce inflation?

1. What does thePhillips Curve show the relationship between? Why does the authors claim that this relationship does not exist?

1. What does theoutput gap show the relationship between? Why does the authors claim that this relationship does not exist?

1. What does the authors state will actually drive down inflation? Explain.

Optimal inflation and the identification of the Phillips curve

Silvana Tenreyro Michael McLeay / 3 Jul 2018

The Phillips curve - a positive relationship between inflation and economic slack - is one of the building blocks of the standard macroeconomic models used for forecasting and policy advice in central banks. On the face of it, recent findings of a breakdown in this relationship would therefore have major implications for monetary policy. This column argues that these findings are perfectly consistent with a stable underlying Phillips curve. The reason is simple: monetary policy will typically seek to reduce output whenever inflation is set to rise above target, blurring the identification of the Phillips curve in the data.

There has recently been much media comment, academic discussion and policy debate devoted to the observation that in many economies, the relationship between inflation and economic slack - the Phillips curve - appears to have weakened or even disappeared.1 Some papers have estimated that the slope of the Phillips curve has flattened over time (Ball and Mazumder 2011, IMF 2013, Blanchard et al. 2015).Others have shown that inflation can be well-approximated and forecast by statistical processes unrelated to the amount of slack (Atkeson and Ohanian 2001, Stock and Watson 2007, 2009, Dotsey, et al. 2017, Cecchetti et al. 2017, Forbes et al. 2017).

On the face of it, these findings could have major implications for monetary policy. The Phillips curve is one of the building blocks of the standard macroeconomic models used for forecasting and policy advice in central banks. A breakdown in the relationship would challenge the wisdom of these models and the usefulness of their forecasts. Arguably, it would call in to question part of the rationale for independent, inflation-targeting central banks. In a recent paper (McLeay and Tenreyro, 2018), we argue that such fears may be misplaced.

Successful monetary policy should hide the empirical Phillips curve

We use a standard conceptual framework (Clarida et al.1999; although similar results would obtain in the classic setting of Barro and Gordon 1983) to show why:

• the empirical disconnect between inflation and slack is exactly what one should expect when monetary policy is set optimally; and
• the result is perfectly consistent with an underlying stable and positively sloped Phillips curve.

Specifically, in our paper the Phillips curve always holds - inflation depends positively on the output gap by assumption. Cost-push shocks can lead to deviations from the curve, but do not alter its slope. But we also assume that monetary policy is set optimally under discretion to maximise welfare, captured by objectives to eliminate slack and stabilise inflation (in line with typical central bank mandates). Given these objectives, good monetary policy will typically seek to eliminate any developing output gaps in order to stabilise inflation at its target. When faced with cost-push shocks it should aim to strike a balance between the two goals. In either case, the central bank's actions seek to reduce output whenever inflation is set to rise above target. This targeting rule imparts a negative correlation between inflation and the output gap, blurring the identification of the (positively sloped) Phillips curve.

If the central bank is successful in achieving its objectives, then equilibrium inflation will completely inherit the statistical properties of the cost-push shocks affecting the Phillips curve. This is entirely in line with recent empirical results in Cecchetti et al. (2017) and Forbes et al. (2017), which suggest that inflation data in the US and the UK can be modelled as an exogenous statistical process, unrelated to measures of slack. It is also consistent with the findings in large-scale models such as Smets and Wouters (2007) that mark-up shocks can explain much of the variation in inflation. This is exactly what one should expect to see under successful, systematic monetary policy.

The identification problem

In our stylised setting, recovering the Phillips curve from the data leads to a classical identification problem. Figure 1 plots the Phillips curve in the model (in blue), alongside the monetary policy targeting rule (in red). In equilibrium we do not observe the Phillips curve, but rather the intersection between the two lines. The situation is analogous to the textbook case of simultaneously determined supply and demand curves.

A nave econometrician running simple OLS regressions will fail to recover the Phillips curve. Indeed, when the Phillips curve is subject to cost-push shocks and when monetary policy perfectly offsets shocks to demand, the data will perfectly trace out the negatively sloped targeting rule, rather than the positively sloped Phillips curve.

Figure 1 Phillips curve and optimal monetary policy with cost-push shocks

Source: McLeay and Tenreyro (2018).

Recovering the Phillips curve

Successful monetary policy will make the Phillips curve harder to see in the data. But it is crucial for monetary policymakers to know whether the underlying Phillips curve is still present (but hidden), or if it has actually disappeared. There are a number of possible solutions to the identification challenge.

1) Shocks to the monetary policy targeting rule (arising from policy errors, lags or changes in policymaker preferences) can help recover the Phillips curve

We show how the observed inflation-output gap relationship depends on the relative variance of cost-push and targeting-rule shocks. If the latter are dominant, the identified parameter will be closer to the true slope of the Phillips curve. Shocks to the targeting rule shift the equilibrium along the Phillips curve, rather than shifting the curve itself (Figure 2). If the variance of the targeting-rule shocks is high enough, then successfully controlling for cost-push shocks such as changes in oil prices should help the econometrician to recover the Phillips curve using standard OLS techniques. The vast VAR literature on the identification of exogenous monetary policy shocks (and their effects on output and inflation) offers an alternative way of distilling the structural Phillips curve relationship.

Figure 2 Phillips curve and optimal monetary policy with targeting-rule shocks