Evolving dynamics of the relationship between US core inflation and unemployment

Labor market dynamics in the US are changing due to long‐term factors including decelerating labor force growth, rising age of the labor force, and the rapid advance of e‐commerce, as well as the one‐time downward adjustment during 2009–2013 of the size of state and local government work forces. We discuss some of the controversies revolving around how to analyze labor markets in this dynamic environment from the perspective of monetary policymaking, given the dual mandate of the Federal Reserve to encourage both full employment and price stability. Our statistical research documents the changing association between US unemployment and core inflation. There was a perceived trade‐off between inflation and unemployment in the 1950s and 1960s that gave way to stagflation in the 1970s, when both unemployment and inflation were rising. The 1980s were a transition period where the trade‐off was perceived to have returned. This trade‐off has not been so clear, however, when one looks at the last twenty years. Since 1995, a period of stable and low inflation was consistently observed despite considerable cycles in the unemployment rate. Our theoretical discussion provides a dynamic interpretation of the shifting nature of labor markets, with the objective of pointing the way for future research while highlighting crucial differences in possible interpretations that could fuel debate, both inside and outside the Fed, over how the Fed should manage its dual mandate. The dynamic changes being seen in US labor markets all suggest that the effectiveness of monetary policy to encourage full employment may be vastly overstated. If this interpretation is correct, the Fed may need to reconsider how to manage its dual mandate and react less aggressively to perceived labor slack that may be due to longer‐term structural shifts over which the Fed has no influence.