In a recent PIIE Policy Brief, David Reifschneider and David Wilcox (blog post here, full paper here) argue that the high inflation in 2021 was largely the result of special factors and that many of these factors are likely to fade in 2022 and 2023. They argue that long-term expectations of inflation have remained stable and, therefore, that the Federal Reserve does not have to hit the brakes too strongly because most of the high inflation will go away on its own. Reifschneider and Wilcox (2022) have generated replies by Joseph Gagnon, Karen Dynan, Jason Furman, and Oliver Blanchard. In this note, we briefly review Reifschneider and Wilcox (2022) and the main counter arguments.
To keep in mind
Reifschneider and Wilcox (2022) claim that inflation will return quickly towards its long-run mean (2 percent). However, a close scrutiny of Reifschneider and Wilcox (2022) assumptions raise several concerns. A slightly different approach (as pointed out in their replies to Reifschneider and Wilcox by Joseph Gagnon, Karen Dynan, Jason Furman, and Oliver Blanchard) results in more persistent inflation dynamics. In this alternative view, the Fed should move toward a federal funds rate of 3 percent or higher to moderate inflation.
What Reifschneider and Wilcox (2022) do
Reifschneider and Wilcox generate forecasts of inflation using estimated expectations-augmented Phillips curve models. These models are specified so that inflation depends on three factors: a weighted sum of lagged inflation and the Survey of Professional Forecasters (SPF) measure of expected long-run inflation, a measure of aggregate labor utilization (slack), and changes in the relative price of nonoil imports. Reifschneider and Wilcox (2022) model predicts that four-quarter core PCE price inflation will moderate to 3.1 percent by the end of 2022 and about 1.9 percent by late 2024. Reifschneider and Wilcox (2022) case for remaining relatively optimistic about the outlook for inflation rests on two main considerations. First, a variety of special factors (i.e. used cars prices, etc..) that boosted inflation in 2021 are unlikely to directly contribute as much to inflation in 2022 and beyond. Second, Reifschneider and Wilcox (2022) claim that inflation has a much stronger tendency now than it did 30 years ago to revert to its longer-term average rate after a shock. Under this property, inflation should move down sharply in the next year or so, especially as the supply situation improves.
Critiques to Reifschneider and Wilcox (2022)
Following the publication of Reifschneider and Wilcox (2022), a series of replies by Joseph Gagnon, Karen Dynan, Jason Furman, and Oliver Blanchard have raised three main concerns.
1. Steeper Phillips curve. As Gagnon (2022) points out, inflation likely responds more to tight labor markets than is assumed in standard forecasting models, including the model of Reifschneider and Wilcox. At the current estimated level of unemployment gap (about -2%), the Phillips curve can be 4-5 times steeper than estimated by Reifschneider and Wilcox (2022) model. Therefore, the current contribution of slack to core PCE price inflation can be as high as 1 percentage point. For this reason, under the assumption that the NAIRU is currently at 5% and will stay at this level going forward, the Gagnon-Collins’ model projects that core (CPI) inflation will remain elevated (at 3.5%) at the end of the medium-term (2023) – see figure below.
2. Stable anchor. As Dynan (2022) points out, “model forecasts reflect historical relationships between the variables in the model. They are thus likely to be most accurate when applied in times that are fairly representative of the period over which the model is estimated”. In other words, it is hard to detect structural breaks in real-time. The preferred specification of the Reifschneider-Wilcox (2022) model—which reflects coefficients estimated using data since 1990—shows a limited role for lagged inflation and a significant role for long-term inflation expectations. However, using the long-run SPF forecast for inflation as a key input into a forecast raises three issues. The first is whether the long-term forecast from a group of economic forecasters is the right way to think about inflation over the next several years. In a way, “the Reifschneider and Wilcox forecast is less the prediction of an economic model and more the restatement of what another group of forecasters think” (Furman (2022)). Second, the relevant time horizon for expectations of inflation is unclear in the data. Short- and medium-run inflation expectations rose sharply over the last year, even as longer-term expectations remained anchored. Short-term expectations, especially by consumers, were not good predictors in the period of stable inflation, but according to Furman (2022) there is reason to take them more seriously now that inflation is more unstable than it has been in 40 years. The third and final issue is that assessing the validity of long-term inflation expectations to forecast actual inflation in real-time is nearly impossible and subject to ex-post large revisions due to structural breaks. On this point, it is worth remembering what happened during the 1970s episode. In his 1970 paper, Gordon found that the autoregressive coefficient of the Phillips curve (λ) was about 0.6, rejecting the accelerationist hypothesis (defined as λ = 1.0), a conclusion strongly endorsed by the participants at the Brookings meeting that year. However, by 1977, all his estimates were equal to 1. True, it took seven years for the coefficient to reach 1, and this was in an environment of higher inflation and a less credible central bank than today. But the lesson is that a conclusion about the autoregressive coefficient can be reached only ex-post; therefore, relying exclusively on an anchored version without questioning the validity of this assumption (or not considering a model with fast adaptive expectations) exposes the econometrician to large out-of-sample misses.
3. Supply-side shocks persistency. Reifschneider and Wilcox (2022) make two implicit assumptions. First, they assume that the relative price of nonoil imports will decline at the average pace seen from 1994 to 2019. Second, and more importantly, they assume that the model residuals that are necessary to explain the behavior of inflation in 2021 will continue to boost inflation in 2022, albeit to a lesser degree that gradually fades to zero. In other words, Reifschneider and Wilcox (2022) assume that the cost-push shocks that have hit the US economy last year are not persistent. While this assumption is reasonable in tranquil times, there is little certainty it will be this time for two reasons. First, nonoil imports are rising way above the pace seen pre-Covid with little signs of plateauing (for the record: nonoil import prices are rising at double digits, 3m/3m a.r., as opposed to negative readings before the pandemic). Second, global supply-chain issues are proving persistent and there are little signs of improvements, even in the most recent data. Therefore, the large residuals observed in 2021 can be more persistent than assumed by Reifschneider and Wilcox (2022).
In sum: for inflation to retrace all or most of its recent rise this year, there needs to be some combination of anchoring of inflation expectations with limited inertia, a substantial reduction in demand relative to overall productive capacity, a linear Phillips curve, and a significant abatement of negative supply shocks.
Comment and implications for the FOMC
There are good reasons to think that the Phillips curve has shifted, as it has done many times in the past, and that the landing will be more complicated than Reifschneider and Wilcox (2022) conclude. Part of the inflation will probably go away on its own (i.e. used cars prices will drop, eventually) but several economists think the Fed may have to increase interest rates by more than 200 basis points to get back to its target. In this respect, we agree with Blanchard (2022): “unless one thinks that all that will be needed is a monotone adjustment of the policy rate to the long-run neutral rate and no more, it makes little sense to talk about a terminal rate. The adjustment is likely to have a bump, with the policy rate staying above the neutral rate until inflation is under control and the rate returns to the long-run neutral rate”. If the equilibrium real funds rate is 0.4 percent, as suggested by FOMC projections, then even if inflation expectations were fully anchored at the Fed’s target of 2 percent, the neutral federal funds rate would be 2.4 percent. As actual inflation was much higher than 2 percent last year, and short-term inflation expectations have moved up as well, the neutral funds rate is probably above 2.4 percent today. A tighter-than-neutral stance may be needed to reinforce the Fed’s commitment to low inflation. Therefore, in our view, the FOMC is (implicitly or explicitly) thinking of moving toward a federal funds rate of 3 percent (or higher).