Cleveland Fed paper looks for reasons for flatter Phillips curve

A more aggressive monetary policy response to economic activity could be flattening the Phillips curve, a paper published by the Federal Reserve Bank of Cleveland finds.

In an economic letter, Filippo Occhino examines business-cycle behaviour and monetary policy responses to try to understand the underlying causes of the flattening Phillips curve.

He finds that when a central bank responds more to economic conditions than inflation, the output gap becomes less volatile.

This is because the correlation between the output gap and the output deviation decreases, Occhino says. As a result, there is a lower correlation between inflation and the deviation of output from its “steady-state level”, which he calls the “output deviation”.

He also finds than an increase in the price stickiness could be flattening the Phillips curve. When prices become more flexible, the output gap becomes less volatile and less correlated with the output deviation. This could lead to less correlation between inflation and output, Occhino says.

If the underlying driver of a flatter Phillips curve is price stickiness, then monetary policy-makers need to make one kind of change to policy, the author finds.

They could increase household welfare by responding less aggressively to output deviations and more so to inflation, Occhino finds. If the monetary policy rule is the key driver of a flatter Phillips curve, then they should respond aggressively to output deviations rather than inflation, he finds.