Scarring effects steepen Phillips curve and alter economic gaps
A Federal Reserve working paper finds that cyclical shocks cause persistent scarring to potential output and the natural rate of unemployment. Incorporating these hysteresis effects steepens estimated Phillips curve slopes fourfold and redefines policy-relevant activity gaps.
When demand leaves permanent marks
Standard unobserved components models assume that slow-moving supply trends remain completely independent of short-term business cycle fluctuations.
The Fed study extends this framework by introducing an endogenous scarring mechanism where transitory demand shocks permanently or persistently alter productive capacity and labor market trends.
Analyzing U.S. data from 1987 to 2024, the authors decompose gross domestic product and unemployment into supply-driven stars and cyclical scarring components.
This structure absorbs much of the medium-term persistence traditionally assigned to the business cycle, resulting in significantly less volatile cyclical estimates.
Consequently, endogenous trends capture the hump-shaped macroeconomic dynamics previously attributed solely to cyclical shocks.
Steeper curves and supply rebalancing
Because the scarring framework assigns lower volatility to cyclical processes, the estimated price and wage Phillips curve slopes become four to five times steeper than in standard models.
The model accounts for swift inflation changes without requiring counterfactually large shifts in real output or excessive cost-push shocks.
This dynamic forces a fundamental rebalancing in historical shock identification: supply-driven stars explain a far greater share of real activity fluctuations.
During the 2008 financial crisis, the natural rate of unemployment rose to 7 percent under scarring, compared to 5 percent in standard models.
Rethinking traditional slack benchmarks
The study convincingly shows that separating supply trends from demand cycles produces flawed policy benchmarks.
Demonstrating much steeper Phillips curves directly challenges long-held central bank assumptions about economic slack.
Yet shifting volatility so heavily onto supply stars may overstate supply-side volatility during deep crises.