WASHINGTON -(Dow Jones)- High unemployment in 2009 likely led to big declines in inflation, suggesting an economic theory known as the Phillips curve may be useful in setting interest rates, according to a paper from the San Francisco Federal Reserve published Tuesday.
In a severe recession like the one from which the U.S. is now recovering, evidence shows that prices drop and unemployment rises just as the Phillips curve states, the San Francisco Fed study shows.
Named for economist William Phillips, who wrote a paper in 1958 examining the relationship between unemployment and inflation, the theory states that when unemployment is high, wage demands diminish. Since labor accounts for the bulk of consumer prices, inflation comes down as a result.
Federal Reserve officials--and economists, for that matter--are split on the Phillips curve school of thought that economic slack brings low inflation, which in turn would call for low interest rates.
Minutes from an August 2009 Fed rate-setting meeting showed that most officials saw substantial slack in the economy leading to subdued wage-and-price inflation over the next few years. However, some officials were skeptical, pointing to the "loose empirical relationship of economic slack to inflation."
The Phillips curve lost empirical support during the 1970s stagflation in the U.S., which saw both high inflation and high unemployment. In the early 2000s, low unemployment and relatively low inflation marked another departure from the economic theory.
San Francisco Fed economists Zheng Liu and Glenn Rudebusch said in the paper that outside of severe recessions, fluctuations in inflation and unemployment rates "do not line up particularly well."
However, they said in the most recent recession that started in late 2007, "our findings suggest that the high level of the unemployment rate over the past year likely contributed to the substantial declines in the inflation rate, as the Phillips curve would predict."
Since the start of the current economic downturn, inflation has dropped sharply and the jobless rate has more than doubled to 10%.
Economic research has a significant bearing on the Fed's interest-rate decisions.
In his most recent speech on Jan. 3, Fed Chairman Ben Bernanke responded to criticism that low rates during 2002-05 contributed to the housing boom and the financial crisis by focusing on a 1993 rule for setting rates devised by Stanford University economist John Taylor.
Copyright 2009 Dow Jones Newswires
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