RECENT INFLATION PERFORMANCE AND THE NAIRU 

  The present combination of low and declining inflation and sustained 
low unemployment would appear to pose a challenge to models of price 
inflation based on the concept of a NAIRU, or 
nonaccelerating-inflation rate of unemployment. As discussed in the 
1997 Economic Report of the President, historical experience indicates 
that the chances are high that inflation will rise in periods when the 
unemployment rate is very low, and fall when unemployment is unusually 
high. The NAIRU can therefore be defined as the unemployment rate at 
which--absent special factors--the odds of falling and rising inflation 
are roughly balanced. Although a specific value of the NAIRU 
represents a forecaster's best estimate of the rate of unemployment 
that can be sustained on average without causing an increase in 
inflation, any estimate of the NAIRU is subject to some degree of 
imprecision, inasmuch as there will be periods when inflation is 
falling even though unemployment is below the NAIRU, and vice versa. 
In addition, the NAIRU itself is not invariant over time, but is 
instead affected by such factors as the demographic composition of the 
labor force and changes in the structure of labor and product markets. 

  The 1997 Report indicated that reasonable estimates for the NAIRU lie 
between 5 and 6 percent, with a midpoint of 5.5 percent. In 1997 the 
unemployment rate averaged 4.9 percent, about one-half percentage 
point below the midrange estimate of the NAIRU. A forecasting model 
built around a NAIRU of 5.5 percent would therefore have predicted 
some acceleration in prices over the course of 1997; one reasonable 
estimate would have been a 0.3-percentage-point increase in core CPI 
inflation. Instead, core CPI inflation finished the year roughly 0.4 
percentage point below its year-earlier rate, although 0.1 percentage 
point of this deceleration can be accounted for by methodological 
changes introduced into the calculation of the CPI. 

  The observed decline in inflation is consistent with the view that 
changes in inflation are influenced by other factors besides labor 
market slack (measured here by the gap between the actual unemployment 
rate and the NAIRU). A number of factors did in fact help mitigate 
inflationary pressure in 1997. First, the costs of providing workers 
with nonwage compensation (such as health insurance) continued to rise 
at a very low rate; as mentioned above, this helped keep growth in 
labor costs from adding to inflation. Second, also as noted above, 
computer prices have recently declined at a faster-than-average rate; 
without this decline, overall inflation would have risen steadily 
since early 1994 (Chart 2-2). Although it is always possible to find 
components of GDP whose prices are growing faster or slower than the 
average, relative price changes for computers are particularly 
noteworthy in that they are largely driven by technological change, as 
opposed to cyclical forces such as shortages in raw materials, 
bottlenecks in production, or rising labor costs. 

(GRAPHIC NOT AVAILABLE IN TIFF FORMAT)

  Overall price inflation has been further reduced by sharp declines in 
the relative price of imported goods, particularly non-oil merchandise 
imports. Since the second quarter of 1995 the relative price of all 
imported goods has fallen by 14 percent, and the relative price of 
non-oil merchandise imports has declined by 15 percent. In part this 
decline in import prices reflects two interrelated factors: 
significant excess capacity--and hence low rates of inflation--abroad, 
and the dollar's appreciation against other major currencies. It is 
difficult to determine precisely what effect this has had on overall 
inflation, but some estimates indicate that this factor could have 
reversed much if not all of the increase in inflation that would have 
been predicted solely from the gap between the actual unemployment 
rate and the estimated NAIRU. 

  Judged from the perspective of a NAIRU model, therefore, it seems 
possible that the economy is currently operating at an unemployment 
rate that is inconsistent with stable inflation over the long run, but 
that the influence of special, possibly transitory factors has 
prevented prices and labor costs from accelerating. Although this is a 
plausible explanation for recent inflation performance, it is 
certainly not the only one; an alternative hypothesis is that 
structural changes in labor and product markets have led to further 
declines in the NAIRU. If true, this would imply that at least some 
portion of the recent decline in the unemployment rate can be 
sustained without an eventual increase in inflation. 

  The rate of unemployment consistent with stable inflation would be 
expected to vary over time in response to such factors as shifts in 
labor force demographics, changes in the relation between workers' 
real wage demands and their productivity, and structural shifts that 
alter the degree of mismatch between workers and jobs (both sectorally 
and regionally). For a number of reasons, however, it is difficult at 
present to justify a large additional reduction in the estimated NAIRU 
on the basis of recent experience. First, the presence of fortuitous 
supply shocks clouds the inflation picture significantly; although it 
is evident that these shocks have contributed to lower inflation, the 
exact extent of this contribution cannot be perfectly gauged. Second, 
although inflation in goods and services prices has not risen as 
unemployment has fallen below 5.5 percent, some acceleration in wages 
has occurred (Chart 2-3), which might reflect labor market tightness. 
Finally, the unemployment rate has been below 5.5 percent for too 
short a time to allow any certainty that the risk of a gradual buildup 
of inflationary pressure is entirely absent. 

  However, a small downward revision to the estimated range of the NAIRU 
is indeed justifiable. A portion of recent inflation performance 
cannot be explained by special factors; moreover, the fact that prices 
have not accelerated as the unemployment rate has fallen below 5.5 
percent suggests that the estimated range should be shifted down. A 
model that accounts for supply shocks such as recent declines in 
relative import prices and that allows the NAIRU to vary over time 
indicates that a reasonable range for the NAIRU now has a midpoint of 
5.4 percent, 0.1 percentage point lower than in previous estimates. 
The Administration's budget forecast has been revised to reflect this 
slightly lower estimated midpoint of the NAIRU's range.

(GRAPHIC NOT AVAILABLE IN TIFF FORMAT)