"Inflation: Mind The Gap" - Response

The article has to do with the Phillips curve, that is, the relationship between unemployment and inflation. The article contends that in normal economic times, a Phillips curve model of inflation is no more useful than a naive model, but that in periods of severe deviations from normality, the Phillips curve better predicts unemployment.

The idea here is that "slack" in the economy, which plays a big role in Federal Reserve monetary policy, is a good predictor of inflation risk. When the unemployment gap is large, that is, the difference between potential (NAIRU) and actual unemployment is large, there is sufficient slack in the economy such that inflation risks are low, and that disinflation is more likely. The implications of this model would suggest the Federal Reserve maintain a low federal funds rate for an extended period, as is current policy. The unemployment rate is projected to decline marginally over the next two years, never reaching NAIRU. This suggests that we're due for an extended period of disinflation, all else equal. We'll see later in the week what the CPI numbers suggest.

I'm not entirely convinced of this relationship based on the model alone. I understand that as long as there is an excess supply of labor, and few job openings, that wages will remain depressed. But I'm not sure that wages are the primary driver of price inflation. It seems that under normal circumstances, higher demand will lead to higher input prices, higher final good prices, and then higher wages. I guess the difference here is that potential price increases cannot lead to wage increases because of the excess labor supply and that consumers can't drive prices higher without a higher wage. I understand the logic, but for some reason it seems counter intuitive to me that increasing demand won't lead to price increases.

I feel like inventory consolidation has a lot to do with the story. When inventories are restored to normal levels, and capacity utilization remains low, its as if we've just come down to a lower "potential" level of output. Unless something changes dramatically we're not going to see an accelerated return to the previous trend. My thinking here is basically that NAIRU might get adjusted upward at some point, giving the model a little less slack, and therefore a little more potential for inflation. If the model is correct, it looks like we're headed for an extended period of disinflation and quite possibly deflation. It wouldn't surprise me to see this trend develop in the short term, but over the entire period of unemployment above NAIRU I can't imagine we're going to see extended deflation.