Staff Working Paper No. 1,018
By Vania Esady, Bradley Speigner and Boromeus Wanengkirtyo
We demonstrate that it is necessary to control for state dependence in the Phillips curve in order to be able to appropriately identify separate slopes for short and long-term unemployment rates. Whereas several existing studies have typically concluded that long-term unemployment is largely immaterial for price pressures, our evidence suggests that the effect of long-term unemployment on inflation is highly state dependent. In particular, reductions in long-term unemployment are found to be significantly inflationary when aggregate unemployment is low, displaying a larger and more immediate peak effect on inflation than short-term unemployment. The explanation for our finding is a direct consequence of allowing for non-linearity in the Phillips curve together with short and long-term unemployment gaps that enter the specification separately. Variation in long-term unemployment typically arises following large recessionary shocks and the Phillips curve also tends to be flatter in deep recessions. It therefore follows that the comovement between long-term unemployment and inflation will be understated in linear regressions. In order to address this, we adopt a flexible methodology that combines non-linearity and heterogeneity in the unemployment duration distribution, enabling us to control for this confounding effect of state dependence on the identification of separate Phillips-curve slopes for short and long-term unemployment. Our results would caution against underweighting long-term unemployment in the inflation-relevant measure of economic slack, especially when unemployment is low.