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Extended version of the paper presented at the ECB Forum on Central Banking in Sintra, Portugal on “Inflation and unemployment in Europe” on May 22, 2015. We thank Larry Ball and Sandeep Mazumder for comments and help, as well as Yangfan Sun and Daniel Rivera for excellent research assistance. Comments by Larry Ball, who was our discussant, led to substantial changes in the second part of the paper. We also thank Zeno Enders, Stephan Danninger, Chris Erceg, Jaewoo Lee, and other IMF colleagues for comments. Our paper builds on Martin and Wilson (2013) and IMF (April 2013) Chapter 3. The online appendix is available at: http://www.imf.org/external/pubs/ft/wp/2015/wp15230app.pdf
“Less plausibly in this case”, because, as far as we know, nobody mentioned such an underlying decrease in growth at the start of the Great Financial Crisis. More recently, however, research has concluded that, at least in the United States, there was indeed a slowdown in productivity starting a few years before the crisis (Fernald 2014).
Martin and Wilson build in turn on Cerra and Saxena (2008), which, using an autoregressive projection model and consensus surveys, documented the behaviour of output following financial crises and civil wars.
Following Harding and Pagan (2002), we set to two quarters the number of observations on both sides over which local minima and maxima are computed, to two quarters the minimum duration in every contraction or expansion phase, and to five quarters the minimum duration between two peaks and two troughs.
To state the obvious: two-sided filters, such as an HP filter, cannot be used for these purposes, as the behavior of output after the recession would affect the estimated trend before the recession. By construction, output would return to the constructed trend, thus negating any level or growth effect of recessions.
To understand the adjustment, note that, if the coefficient on the quadratic term is c, the derivative of the growth rate relative to time is equal to 2c, and thus, after n quarters, log output will be lower relative to a linear trend by 2c(0+1 + … +(n-1)) = cn2
In the literature, results by Haltmaier (2012) – using a methodology based on HP filters – and Martin and Wilson (2013) also suggest that recessions (in general) lead, in many cases, to a lower level of output. Studies focusing on deep recessions, such as Cerra and Saxena (2008), Reinhardt and Rogoff (2009) and IMF WEO (2009), among many others, also highlight highly persistent effects on the level of output.
For example, Ennis and Keister (2003) have illustrated in a theoretical model how a higher probability of banks runs can reduce the stock of capital and output as well as the long run growth rate. Empirical evidence in this regard has been provided by Ramirez (2009) in his analysis of the 1893 US financial crisis.
A model along these lines is presented and estimated in Blanchard, L’Huillier and Lorenzoni (2013). The model, however, assumes that the news is bad news about the level of productivity, not bad news about the growth rate.
Robert Gordon, however, offers a different interpretation of the fact. He argues that the decrease in productivity during the boom is due to overoptimistic expectations by firms, which hire too many workers. He sees the recession as correcting this over-hiring, and thus correcting the decrease in productivity. This, however, would not explain why productivity growth remains permanently lower after the recession.
We classify as recessions with increasing inflation those for which the average inflation during the year before the start of the recession is below the average inflation during the recession. Recessions with declining inflation capture the rest.
We redid the computations presented earlier for this smaller sample of recessions. In general, the results are rather similar. The proportion of recessions followed by an output gap is slightly larger (75% versus 69% for the whole sample).
Capturing in a more poetic way the argument in the previous paragraph, the title of the study was called “The dog which did not bark”.
Further details about the specification of the equation are given in Appendix 1 of the IMF chapter.
The appropriate specification of the Phillips curve, if there is indeed one, is far from settled. The above results were robust to either allowing the natural rate to depend partly on the actual unemployment rate -reflecting a crude form of the hysteresis issue dealt in the previous section - or replacing the unemployment rate with the short-term unemployment rate.
In the case of the United Kingdom, there appears to be a stable and significant relation between wage inflation, expected inflation and unemployment (Broadbent, 2014). What appears to have broken down is the relation between wage inflation and price inflation.
We do not look at the euro area as a whole. Work by Andrle et al. (2013) also suggests the presence of a significant relation between inflation and unemployment there as well.
At the microeconomic level, there is substantial evidence of a binding zero lower bound on wage changes in Portugal, which might explain why the coefficient on the unemployment gap has become insignificant. The question is then why the same has not happened in other countries, which also have low wage inflation.
We are not aware of a derivation of optimal monetary policy under hysteresis. For a beginning, see Gali (2015).
It is indeed often the case that estimates of output gaps associated with recessions are revised down ex post.