New York Fed: "Why Didn’t Inflation Collapse in the Great Recession?"

From the Federal Reserve Bank of New York's Liberty Street Economics blog:

GDP contracted 4 percent from 2008:Q2 to 2009:Q2, and the unemployment rate peaked at 10 percent in October 2010. Traditional backward-looking Phillips curve models of inflation, which relate inflation to measures of “slack” in activity and past measures of inflation, would have predicted a substantial drop in inflation. However, core inflation declined by only one percentage point, from 2.2 percent in 2007 to 1.2 percent in 2009, giving rise to the “missing deflation” puzzle. Based on this evidence, some authors have argued that slack must have been smaller than suggested by indicators such as the unemployment rate or deviations of GDP from its long-run trend. On the contrary, in Monday’s post, we showed that a New Keynesian DSGE model can explain the behavior of inflation in the aftermath of the Great Recession, despite large and persistent output gaps. An implication of this model is that information about the future stance of monetary policy is very important in determining current inflation, in contrast to backward-looking Phillips curve models where all that matters is the current and past stance of policy.

        In the New Keynesian DSGE model, inflation depends on a measure of slack and on expected inflation. In turn, expected inflation is determined by expected future marginal costs. Putting the two things together, today’s inflation depends on current and expected future marginal costs. According to the model, inflation did not fall much during the recession because expectations of future marginal costs, and therefore inflation expectations, remained anchored. In other words, marginal costs were expected to revert back to their normal level even though current marginal costs were low.

        This raises the question of what determines the expected reversion of marginal costs. In our paper “Inflation in the Great Recession and New Keynesian Models,” we show that if the prices of individual goods are sufficiently sticky, then monetary policy can have substantial effects on future marginal costs and therefore on inflation. Specifically, if the central bank is committed to stabilize inflation around its target, then it will lower its policy rate and indicate that it will maintain it at a low level for an extended period of time when output is below potential. This announcement tends to lower longer-term rates, which stimulates consumption and investment demand, and in turn raises expectations of future marginal costs....MORE

See also Monday's "Inflation in the Great Recession and New Keynesian Models".