One recent trend that is particularly disturbing is stagnation in the formation of new firms. Statistics from the Bureau of Labor Statistics (BLS) show that the number of establishments in operation for less than one year rose between the mid-1990s, when the data start, and the early 2000s. But, smoothing through the ups and downs of the business cycle, new firm formation has been roughly flat since then. Moreover, the number of individuals working at such firms stands almost 2 million below its peak in 1999. Given the role of innovation by entrepreneurs and the well-documented importance of successful young firms in creating jobs, these trends are disheartening.
…
One recent trend that is particularly disturbing is stagnation in the formation of new firms. Statistics from the Bureau of Labor Statistics (BLS) show that the number of establishments in operation for less than one year rose between the mid-1990s, when the data start, and the early 2000s. But, smoothing through the ups and downs of the business cycle, new firm formation has been roughly flat since then. Moreover, the number of individuals working at such firms stands almost 2 million below its peak in 1999. Given the role of innovation by entrepreneurs and the well-documented importance of successful young firms in creating jobs, these trends are disheartening.

In response to a question about whether he was surprised that the public felt his views had changed radically.

In some ways, yes, I was surprised.

I was surprised by the reaction in the sense that I felt I was putting a lot of weight on the price stability mandate by suggesting that even an inflation outlook—medium-term outlook, two-year outlook—that is a quarter percentage point higher than 2 percent should be viewed as a cause for concern. I’m not saying we’re going to raise rates at that point, just to be clear. But I’m saying it’s a time to consider raising rates.

I felt that I was actually being highly respectful of the price stability mandate, and properly so. With that said, I think it is true that to suggest that unemployment could get as low as 5 1/2 percent without pushing inflation above 2 1/4 percent, that was a change in my thinking relative to where I was in April. That change in my thinking came just because of the data on inflation and reading a ton of work that had been done on the factors generating high unemployment.

…

I gave a speech about structural unemployment in August 2010 in which I pointed to the shift in the “Beveridge curve.” This is a plot of unemployment and vacancies over time. It has shifted outward, meaning that, roughly speaking, it looks like firms are having a surprisingly hard time filling their job openings given how many people are looking for jobs. There are other interpretations of this, though, as there always are in economics. So, I laid out my concerns about that shift in August 2010. That shift is still there in the data.

But what’s changed since August 2010 is that there’s been a lot of research trying to parse out what is responsible for this shift. That work goes through a number of factors. It’s summarized in a paper that Professor Edward Lazear gave at the Kansas City Fed’s Jackson Hole Conference earlier this year [2012].8 As a Fed president, I was already aware of a lot of that work because much of it has been done within the [Federal Reserve] System.

What this work usually does is look, factor by factor, at how much unemployment is caused by each structural factor. Generally, the answer is not a lot. You can get to maybe a percentage point, or point and a half, of the increase in unemployment since 2007, due to structural factors, something like that.

Those studies were very important in shaping my thinking. Another thing that happened was that inflation over the course of 2012 came in considerably lower than I had anticipated. Both of those things mattered in shaping how I thought about inflation going forward.

While I see little risk of inflation in the near term, I do see greater risk of higher inflation in the intermediate to long term for several reasons. First, monetary policy is extremely accommodative. We have expanded the Fed's balance sheet to an unprecedented degree since last fall and have kept interest rates at historically low levels. Second, I put less weight than many other economists do on the idea that economic slack or low resource utilization is a reliable predictor of inflation.

Today, I often hear some forecasters argue that inflation will remain low in the coming years because the slack in the economy is not likely to disappear for some time. Yet, several empirical studies have shown that economic slack is difficult to measure with any accuracy. It is particularly hard to measure slack near the turning points in business cycles, so making policy decisions based on measures of such slack becomes problematic.

[T]he level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process.  When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise.  Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall. 

Over the past two years, economic growth has averaged just over 3 1/4 percent, moderately above current estimates of the growth rate that is sustainable in the long run. As a result, the economy now appears to have moved within range of the full utilization of its resources—in other words, the slack in labor and product markets that was apparent a year ago has most likely been eliminated.

Without the contribution of the global workforce, moreover, the quantity and variety of goods and services available in the United States would diminish. I have argued, within the temple of the Fed and without, that globalization has in these and many other ways expanded our concept of “capacity constraints” and redefined our sense of “resource utilization.” It has helped tame inflation. That has been the trend of recent years. But it has not exorcised for once and for all time the demon of inflation.

The general contour of economic activity that most forecasters are expecting, in which they see little change in resource utilization over the year, should be consistent with relatively stable core inflation. As I noted earlier, the unemployment rate is now at a five-year low of 4-3/4 percent. More important, it and other indicators of resource utilization--such as the industrial capacity utilization rate--are now at levels at which, in the past, little or no economic slack remained. At this point, we have seen few signs of upward pressure on labor compensation or core inflation. Although we have experienced run-ups in prices of commodities, such as building supplies, that are more sensitive to changes in supply and demand conditions and in prices of energy-intensive commodities and services, the pass-through to core inflation appears to have been limited.

Despite the relatively moderate increases in prices and costs that we have observed lately, the capacity utilization rate and the unemployment rate have recently reached zones that on occasion in the past have been associated with the beginnings of upward pressure on inflation. Of course, the past is not always a good guide to the future, in part because a great deal of uncertainty surrounds the relationship of resource utilization and inflation. For instance, we cannot directly observe full capacity of either labor or production resources; consequently, we can never be certain what level of activity represents the full utilization of capacity.

In addition, measurement issues aside, the empirical evidence of the past half-century suggests that the relationship between utilization and inflation can shift over time. Unfortunately, we typically are only imperfectly aware of the changes and their magnitudes in real time. In the 1990s, that relationship was affected by, among other things, changing trends in the growth rate of productivity and innovations in the structure of labor markets, such as increased use of temporary help supply.

These uncertainties mean that we, as policymakers, need to keep not only an open mind about estimates of the economy's potential but also a close eye on the various indicators of costs and prices so that we can recognize incipient price developments and react to them as early as possible. But we also must recognize that, by the time evidence of accelerating prices becomes definitive, containing inflation pressures could entail disruptive economic adjustments. So despite the uncertainties, we must evaluate all the evidence and make our best judgments about the oncoming risks to sustained good economic performance. In the current circumstances, as the Federal Open Market Committee has said, the economic climate appears to be one in which further increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

I think that there are pockets of tightness in both the physical capacity and the labor market but there are a lot of other places where there's a lot of excess capacity. So I think the economy is on a good solid course and I don't see any reason, in my own view, to say that we're in any sort of difficult situation.

So what does the limited research on resource utilization and output gaps tell us? There are a few key, but preliminary findings from work done at the Bank for International Settlements...and some as yet unpublished work done by several of our Dallas Fed economists. Here are a few key points:
- The relationship between measures of domestic economic slack, such as industrial capacity utilization, and domestic inflation seems to have declined across a broad range of advanced countries in recent years.
- At the same time, proxies for global slack—such as unemployment rates and output gaps in a wide array of countries—seem to be of growing importance.
- And for some countries, including—and to my mind especially—the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.