(I)t strikes me as reasonable to expect the U.S. economy to regain positive momentum sometime in 2009, for several reasons. First, monetary policy is now quite stimulative and real interest rates are quite low. Second, the energy and commodity price shocks that dampened economic activity last year have subsided already or are in the process of doing so. And third, as I said, the drag from declining residential investment seems likely to diminish significantly in the next year. In fact, I would be surprised if we don’t see a bottom in housing construction sometime in 2009.

While the downturn in real economic activity is going to pose challenges for monetary policy in the period ahead, it’s essential that we not let inflation drift from view. Since 2004, overall inflation has trended upward, and has been higher than I would like over the last few years. Much of the acceleration we saw last year reflected energy prices, however, and with oil prices down, we have seen overall inflation subside in recent months. Moreover, many economists are forecasting relatively low inflation in the months ahead, on the grounds that widening economic slack is generally associated with declining price pressures. I would be cautious about relying on this correlation as a causal relationship, however, even though it is detectable in many datasets.⁶ There have been times in the past when inflation declined only temporarily when activity slowed, and re-accelerated when the recovery began. And while it may seem premature to be worrying about how inflation behaves after the recession is over, we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle.

An efficient monetary policy {following an oil shock} should attempt to facilitate the needed economic adjustments so as to minimize distortions to economic efficiency on the path to achieving, over time, its dual objectives of price stability and maximum employment.⁹

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.  By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.  Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

An inability to measure the output gap in real time obviously limits the usefulness of the concept in practical policymaking.  On the other hand, to argue that output gaps are very difficult to measure in real time is not the same as arguing that economic slack does not influence inflation; indeed, the bulk of the evidence suggests that there is a relationship, albeit one that may be less pronounced than in the past.⁷ 

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.

On the other hand, as Christy and David Romer (2002) have pointed out, the Federal Reserve in the 1970s overestimated the cost of reducing inflation because estimates of sacrifice ratios by Arthur Okun and other economists at that time proved to be too high.¹² As a historical note, this provides one explanation for the Federal Reserve’s tolerance of such high inflation at the time. The disinflation after October 1979, carried out by the Federal Reserve under the leadership of Paul Volcker using words, procedures, and actions that were a sharp break from the past, produced a much lower cost of disinflation than policymakers had anticipated during the 1970s.

Policymakers in the 1970s--the Federal Reserve among them--were dealt a very bad hand that, for a variety of reasons, they played poorly.

...

Not only were the output costs of disinflation seen to be high but also the monetary policy needed to bring inflation down was consistently miscalculated--economists during the 1970s persistently overestimated both the speed and magnitude of the slowdown in real activity and inflation that would result from a given rise in the federal funds rate. Part of this miscalculation reflected a judgment that the economy and financial markets were fragile and that small changes in market interest rates would have major effects on aggregate spending (for example, as a result of disintermediation induced by ceilings on the interest rates that banks and thrifts could pay).