An Empirical Analysis of Inflation in OECD Countries (Preliminary)*

Jane Ihrig and Jaime Marquez

January 2003

Federal Reserve Board

Washington, DC 20551

One of the most remarkable macroeconomic developments of the past decade has been the joint reductions in inflation and unemployment rates across industrial countries. For the United States, these seemingly contradictory developments have been reconciled in terms of three factors: (1) an acceleration in productivity, (2) structural changes in labor markets that lowered the natural unemployment rate (NAIRU), and (3) improved credibility of monetary policy. Here we ask whether comparable factors are at work in foreign industrial countries. To address this question, we empirically characterize the relationship between inflation, the unemployment rate and structural factors using an extended Phillips curve model with quarterly data through 1994. By undertaking counterfactual simulations from 1995 to 2001, we quantify the separate contributions of unemployment rate movements, labor-market reforms (that affected the NAIRU), and productivity developments on inflation. In line with previous work on the United States, we find the main structural factor reducing inflation in the United States to be productivity advancement. For foreign countries, however, continued labor-market slack exerted downward pressure on inflation. The persistence of this slack stemmed, in part, from structural reforms that lowered the NAIRU while the unemployment rate was declining.

*We would like to thank Steven Kamin for numerous comments on the evolution of this paper; Flint Brayton, Jon Faust, David Lebow and Deb Lindner offered important suggestions that improved this version of the paper. We have also benefited from Olivier Blanchard, Oyvind Eitrheim, Neil Ericsson, Joe Gagnon, Joe Gruber, Bill Helkie, Karen Johnson, David Reifschenider, Nathan Sheets, Sandy Struckmeyer, and Bob Tetlow. We are especially grateful to Carter Hemphill for all his work; Marcus Loveland, Patti Teagle and Shing-Yi Wang also provided invaluable research assistance. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.