WHY hasn't there been deflation? That has been one of the central mysteries of the Great Recession and its aftermath. In the 1930s soaring unemployment led to galloping deflation. In the early 1980s a 4.5 percentage point increase in the unemployment rate came alongside a drop in the core inflation rate from about 12% to under 3%. American unemployment rose by more between 2007 and 2010. And yet core inflation dropped only a bit, from a little over 2% prior to the recession to a low of 0.6% in 2010. Inflation has since recovered to 2% despite continued high unemployment. The experience across the rich world has been broadly similar.

On the face of things, the answer is simple: inflation did not fall by much because central banks did not want it to. In the 1930s, central banks didn't care about deflation or didn't appreciate its costs and allowed it to occur. In the 1980s, disinflation was the explicit goal of monetary tightening. But in the 2000s, central banks worldwide responded aggressively to falling inflation, slashing policy rates to near zero, deploying quantitative easing, and using new communication strategies to raise inflation expectations back to target.

Yet that doesn't really solve the mystery. The question is: if unemployment and disinflation typically go together, and if central banks effectively prevented disinflation, then why is there still so much unemployment?

That question is the subject of a chapter in the International Monetary Fund's new World Economic Outlook, and of this week's Free exchange column. The IMF studies the experience of advanced economies over the past half century and reckons that central bank credibility, a product of central-bank success defeating the inflation of the 1970s, helps explain the phenomenon:

When central banks whipped inflation in the early 1980s and adopted low targets for it, they firmly anchored beliefs about future growth in prices and wages. This credibility is self-reinforcing. Workers who expect prices to rise only slowly tend not to push as hard for higher wages. That helps firms to keep costs and prices down. When the crisis struck, this process also helped avert deflation. If prices are not expected to drop, workers are less likely to accept wage cuts. Anticipating stable wage demands, employers are more reluctant to cut prices... As inflation has become more anchored, its links with other economic indicators have weakened. In a study of 21 rich countries since the 1960s, the IMF shows that changes in unemployment now influence inflation much less than in the past (see right-hand chart). Without the breakdown in this relationship, America’s economy would have faced deflation rates approaching 3% in the wake of the recent recession, the IMF notes.

What does this mean for business cycles, exactly? Well, one outcome may be that central banks accustomed to a much tighter link between unemployment and inflation will underestimate the severity of a given shock. To the extent that the Fed was watching inflation for hints about the seriousness of the downturn in 2008 and after, it will have underresponded. This was probably true to some extent in 2008 and 2009, but it shows up most clearly in the fact that the Fed didn't begin "QE2" until 2010; unemployment had been very high for several years by that point, but only then did disinflation look a serious threat.

But another question is whether the link between inflation and unemployment has broken down or merely changed. Stabilisation of inflation may actually imply a shift in economic volatility to other variables. To asset prices, for instance. Low and stable inflation may help generate asset-price booms by making borrowing and risk-taking more attractive. It may also raise the return to capital by restraining wage growth. As a recent Daily chart post demonstrated, the Great Moderation coincided with big gains—and wild swings—in equity prices (not to mention the most extraordinary global housing boom in modern memory).

But stable inflation may also help translate variations in demand into quantity shifts rather than price shifts. The column excerpt above tells part of the story. Workers expecting prices to stay flat amid falling demand will resist wage cuts, and firms expecting workers to resist wage cuts will be reluctant to cut prices. Instead firms will produce and sell less and lay off workers, turning a given shock into much more of a real output loss.

In fact, this potential problem was anticipated. Back in 1988 Larry Ball, Greg Mankiw, and David Romer contributed a Brookings Paper on Economic Activity, titled "The New Keynesian economics and the output-inflation trade-off". They note that when inflation is high firms and workers adjust their prices and wage demands often, making prices highly responsive to demand shifts. When inflation is low, by contrast, firms and workers change prices much less frequently, building much more nominal ridigity into the economy. They write:

[O]ur finding that average inflation affects the short-run output-inflation trade-off is important for policy. For example, it is likely that the trade-off facing policymakers in the United States has changed as a consequence of disinflation in the 1980s. Our estimates imply that a reduction in average inflation from 10 percent to 5 percent substantially alters the short-run impact of aggregate demand.

And they conclude:

In countries with low inflation, the short-run Phillips curve is relatively flat-fluctuations in nominal aggregate demand have large effects on output. In countries with high inflation, the Phillips curve is steep-fluctuations in demand are reflected quickly in the price level. The same finding emerges when we examine the change in the trade-off over time. Countries that experience an increase in average inflation also typically experience an increased responsiveness of prices to aggregate demand.

That the disinflation of the 1980s has generated a flattening of the Phillips curve is precisely what the IMF demonstrates:

In the right panel above, compare the grey and blue lines to the green, which represents the most recent recession.

The broader implication of this work is perfectly clear. Central banks must either raise their inflation targets to reduce the extent to which demand shifts generate large real losses, or they must adopt and stabilise a new measure of demand, since inflation is obviously no longer adequate. One very straightforward alternative would be nominal GDP. Central banks have effectively moved in this directly by raising the weight placed on unemployment in their reaction functions—as seen in the Fed's new "threshold" approach to policy. The IMF's work suggests that these sorts of policies can't, or at least shouldn't, be abandoned once a full recovery is accomplished.