Potential output and inflation dynamics after the Great Recession

Abstract

Ever since the end of the Great Recession, the US economy has experienced a period of mild inflation, which contradicts with the output–inflation relationship depicted by a traditional Phillips curve. This paper examines how the permanent output loss during the Great Recession has affected the ability of the Phillips curve to explain US inflation dynamics. We find great similarity among several established trend–cycle decomposition methods: potential output declined substantially after the Great Recession. Due to the fact that a lower level of potential output implies a lesser deflationary pressure, we then show that the Phillips curve does predict a period of mild inflation. This finding is largely consistent with the observed data.