And in the area of monetary policy, the dynamics of inflation both during and following the recession have presented puzzles. For instance, why is inflation both here and abroad remaining stubbornly low today, even as the economic recoveries in the U.S. and the Euro area strengthen, in part boosted by highly accommodative monetary policy? In Boston, we have examined the extent to which a number of factors might explain recent behavior time-variation in the slope of the Phillips curve, a reduced impact of relative prices (especially oil) on inflation, survey measures as proxies for short-run and long-run inflation expectations, and downward nominal wage rigidities. While these factors appear to provide partial explanations, no effects singly or severally provide a complete accounting of recent inflation behavior. Given these uncertainties about inflation dynamics, we have reason to have less confidence than usual in the inflation forecasts from our suite of models, many of which would suggest a gradual rise toward the Fed's inflation target in coming quarters. This makes the current low level of inflation more troubling from the perspective of risk management. So, in short, we need to better understand inflation dynamics.

I think the evidence shows that over the past 25 years most supply shocks have been transitory – and have had no long-lasting imprint on longer term inflation, or on inflation expectations.

 Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.

The evidence from these so-called autoregressions with U.S. data suggests that inflation may have grown less persistent over time...  Finally, it’s worth noting that this is not just a U.S. phenomenon, as some studies have found similar results for a number of other countries.

In other words, the evidence suggests that the Phillips curve has flattened.

The finding that inflation is less responsive to the unemployment gap, if taken at face value, suggests that fluctuations in resource utilization will have smaller implications for inflation than used to be the case. From the point of view of policymakers, this development is a two-edged sword: On the plus side, it implies that an overheating economy will tend to generate a smaller increase in inflation. On the negative side, however, a flatter Phillips curve also implies that a given increase in inflation will be more costly to wring out of the system. We can quantify this latter consideration using the so-called sacrifice ratio--the number of years that unemployment has to be 1.0 percentage point greater than its natural rate to reduce the inflation rate 1.0 percentage point. Averaging estimates obtained from a comprehensive battery of equation specifications suggests that the sacrifice ratio may be 40 percent larger--that is, it may be 40 percent more costly to reduce inflation than it was two decades ago.

In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once we take the rising share of imports into account, the influence of import prices on core inflation in the United States has not changed much in the context of reduced-form forecasting models.⁶ At the same time, the influence of exchange rate movements on import prices--the so-called pass-through effect--may have fallen substantially, at least according to some studies.

The broader lesson to take away from this Report is that inflation dynamics have evolved significantly over the last 50 years, and inflation expectations appear to be forward-looking. To again paraphrase the late Milton Friedman, inflation is always and everywhere an expectational phenomenon.