Evolving dynamics of the relationship between US core inflation and unemployment

• Author: Bluford H. Putnam,Samantha Azzarello
• Date: 01 April 2015
• DOI: http://doi.org/10.1016/j.rfe.2015.02.002
• Published date: 01 April 2015

Evolving dynamics of the relationship between US core inflation

and unemployment☆

Bluford H. Putnam ⁎, Samantha Azzarello

CME Group, Inc., Un ited States

abstractarticle info

Availableonline 18 February 2015

JEL classification:

E40

E43

E52

E61

Keywords:

Dual mandate

FederalReserve

Inflation

Employment

Unemployment

Labor market dynamics in the US are changing due to long-term factors including decelerating labor force growth,

rising age of the labor force, and the rapid advance of e-commerce, as well as the one-time downward adjustment

during 2009–2013 of the size of state and local government work forces. We discuss some of the controversies re-

volving around how to analyzelabor markets in this dynamic environment from the perspectiveof monetary

policymaking, given the dual mandate of the Federal Reserve to encourage both full employment and price stability.

Ourstatistical researchdocuments the changingassociationbetween US unemploymentand core inflation. There

was a perceived trade-off b etween inflation and unemployment in the 1950s and 1960s that ga ve way to

stagflationin the 1970s, when bothunemployment and inflationwere rising. The 1980swere a transition period

where the trade-off was perceived to have returned. Thistrade-off has not been so clear, however, when one

looks atthe last twenty years. Since1995, a period of stableand low inflation was consistentlyobserved despite

considerablecycles in the unemployment rate.

Our theoretical discussion provides a dynamicinterpretation of the shifting nature of labor markets, with the

objectiveof pointing the way forfuture research while highlightingcrucial differencesin possible interpretations

that couldfuel debate, both inside and outsidethe Fed, over how the Fedshould manage its dual mandate.The

dynamic changes being s een in US labor markets all s uggest that the effectiveness of monetary polic y to

encourage full employme nt may be vastly overstated. If this interpr etation is correct, the Fed may need to

reconsider how to manage its dual mandate and react less aggressively to perceived labor slack that may be

due to longer-termstructural shiftsover which the Fed has no influence.

© 2015 ElsevierInc. All rights reserved.

1. Introduction

In this research, we discuss som e of the controversies revol ving

aroundhow to analyze labor marketsfrom the perspectiveof monetary

policymaking. Ourcentral theme is that the interaction between labor

market conditionsand inflation is inherently dynamic. In thewords of

the venerableJoan Robinson(1972),“There is no suchthing as a normal

period of history. Normality is a fiction of economictextbooks.”Accord-

ingly, any interpretation oflabor market data built on assumed rever-

sion to some “average”or “normal”economic state is li kely to be

wrong. This observation is particu larly relevant for Federal Reser ve

(Fed) decision making,given the dual mandate to encourage both full

employmentand price stability.Indeed, therehas been a healthy debate

within the economics profession concerning the nature of how these

two mandates com plement or collide with each o ther.

Our statisticalresearch simply documents the changingassociation

between US unemployment and core inflation.There was a perceived

trade-off between inflation and un employment in the 1950s and

1960s that gaveway to stagflation in the 1970s,when both unemploy-

ment and inflation were rising. The 1980s were a tr ansition period

where the trade-offwas perceived to have returned. Thistrade-off has

not been so clear, however, when one looks at the last twenty years.

Since 1995, a period of stable and low inflationwas consistently observed

despite considerable cycles in the unemployment rate.

With this statistical background, we turn to theoretical issues and

practical challenges to providea dynamic interpretation ofthe shifting

nature of the inflation and unemployment relationship.Our objective

is to point theway for future research whilehighlighting crucialdiffer-

ences in possible interpretations that couldfuel debate, both insideand

outsidethe Fed, over how the Fed shouldmanage its dual mandate.We

contrast a hypothetical“standard view,”premised on a post-recession

return to normality, against a “dynamic view,”which highlights the

challengesof interpreting labor marketdata in light of the aging of the

work force, seculardeceleration of labor forcegrowth, and the impacts

Reviewof Financial Economics 25 (2015)27–34

☆The researchviews expressed herein are those of the author and do not necessarily

represent the views of the CME Groupor its affiliates. All examples in this presentation

are hypothetical inter pretations of situations and are used for e xplanation purposes

only.This researcharticle and theinformationherein should not beconsidered investment

adviceor the results of actual market experience.

⁎Correspondingauthor at: CME Group,Inc. 20 S. Wacker St. Chicago,IL 60606 USA.

E-mailaddress: blu@bayes1.com(B.H. Putnam).

http://dx.doi.org/10.1016/j.rfe.2015.02.002

1058-3300/©2015 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe