Posts filed under “Inflation”
Drilling Down into Core Inflation: Goods versus Services
M. Henry Linder, Richard Peach, and Robert Rich
Liberty Street Economics, June 05, 2013
Among the measures of core inflation used to monitor the inflation outlook, the series excluding food and energy prices is probably the best known and most closely followed by policymakers and the public. While the conventional “ex food and energy” measure is a composite of the price changes of a large number of different products and services, almost all models developed to explain and forecast its behavior do not distinguish between the goods and services categories. Is the distinction important? Here, we highlight the different behavior and determinants of goods inflation and services inflation and suggest, based on preliminary analysis, that we can improve the forecast accuracy of this conventional core inflation measure by combining separate inflation forecasts of the two categories.
As specified in the Federal Reserve Reform Act of 1977, the Federal Reserve’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Given long and variable lags between changes in monetary policy and the subsequent impact on the economy, meeting these goals is greatly facilitated by being able to accurately forecast the behavior of inflation over a one-to-two-year horizon. This, of course, is easier said than done, as headline inflation measures, such as Consumer Price Index (CPI), tend to be quite volatile, due in large part to sharp swings in energy and food prices.Because of the volatility in headline inflation, policymakers have relied on core inflation measures designed to differentiate between transitory and persistent price changes to help guide their decision making. Among the measures of core inflation, the “ex food and energy” series has been the most widely adopted for this purpose (see this paper by Timothy Cogley for a discussion of other core inflation measures). This measure, shown in the chart below, is a much less volatile series that is indicative of lower-frequency changes of the general price level and has also proved to be a more accurate predictor of headline inflation than past headline inflation.
However, models developed to explain and forecast core inflation—such as Phillips curve models—do not have a particularly good track record, to the point that there is disagreement regarding the fundamental determinants of inflation.
One possible explanation for this state of affairs is that core inflation is a composite of the price changes of a large number of different products and services that behave quite differently over time. The next chart presents core inflation at one level of disaggregation—commodities less food and energy commodities (or core goods) and services less energy services (or core services). Note that the absolute level of inflation of these two categories is quite different as are their weights in the core CPI; the weight of core goods was 34 percent in 1985, but was just 26.1 percent in 2012. Additionally, over the past decade, the two inflation rates have generally moved inversely to each other.
It seems likely that the divergence in the behavior of goods inflation and services inflation may also carry over to their determinants. To explore this idea, we examine the relationship over the period since 1985 between each inflation series in the previous chart and two variables considered to be important in predicting inflation: long-run inflation expectations and the level of domestic resource utilization. Resource utilization provides a gauge of the balance between aggregate demand and supply in an economy. One of the most widely used measures of domestic resource utilization is the unemployment gap—the difference between the unemployment rate and the estimate of the time-varying Non-Accelerating Inflation Rate of Unemployment (NAIRU) from the Congressional Budget Office (CBO).
The next two charts present scatter plots of the four-quarter-ahead inflation rates (period t to t+4) of core services and core goods, respectively, less a measure of ten-year expected CPI inflation (period t) from the U.S. Survey of Professional Forecasters, versus the CBO unemployment gap (period t). For core services, there is a nonlinear, negative relationship between the inflation rate and the unemployment gap. For core goods, however, no such relationship is present.
What Explains Movements in Services Inflation and Goods Inflation?
Based on the three charts above, the behavior and determinants of core services inflation and core goods inflation differ significantly. Can we say more about this? To do so, we have developed and estimated separate models for core CPI services inflation and core CPI goods inflation using quarterly data from 1986:Q1 to 2012:Q4. We can provide the following summary of the results.
The core services inflation model draws upon the modeling approach outlined in this Federal Reserve Bank of Boston paper by Jeffrey Fuhrer, Giovanni Olivei, and Geoffrey Tootell. We find a strong relationship (both economically and statistically speaking) between core services inflation and long-term inflation expectations. There is also an important nonlinear relationship between core services inflation and the unemployment gap, indicating that the impact of changes in labor market slack on core services inflation depends on the level of slack itself.
For the core goods inflation model, the results suggest a very different set of factors influencing the behavior of the series. We find persistence in the series, that is, core goods inflation depends on its own past value. Relative import price inflation—growth in (non-petroleum) import prices less core goods inflation—also matters, suggesting goods prices act as the linkage between supply shocks and core inflation. There is also evidence of a relationship between core goods inflation and expected inflation, but that the relevant inflation expectations are associated with a short-term (one-year) horizon. Last, we find no meaningful effect of the unemployment gap on core goods inflation, consistent with commentators who contend that it is global (and not domestic) economic slack that impacts core goods inflation.
The Whole versus the Sum of the Parts
Taken together, the evidence supports the view that the behavior and determinants of core services and core goods inflation are quite different. Why might this matter? Based on some preliminary work, there appear to be gains in the forecast accuracy of aggregate core inflation from using separate models for core services inflation and core goods.
The estimated models can be used to generate forecasts of core services inflation and core goods inflation, which can then be combined using the relative weights of each category in the core CPI. To provide a basis of comparison, we also produce forecasts from an estimated Phillips curve model of aggregate core CPI inflation that uses long-term inflation expectations, the unemployment gap, and relative import price inflation as explanatory variables.
We estimate the models from 1985:Q1 to 2004:Q4, and then forecast out-of-sample for the post-2004 Q4 period. To construct forecasts of the “composite model,” we use weights of 28 percent for core goods and 72 percent for core services—the relative weights in the core CPI in 2004. As shown above, the forecasts from the composite model capturing the differences in the determinants of the inflation process of core goods and core services are over 65 percent more accurate than the forecasts from the Phillips curve model ignoring those differences. While both models generally track the slowing in core inflation during the recent recession, the forecasts from the composite model have done a better job picking up the subsequent rebound in core inflation. Although they are not shown, we obtain similar results based on the post‑2007 Q4 period.
While we recognize our analysis is preliminary, the results suggest that a further exploration of core services inflation and core goods inflation and their role in the core inflation process is warranted.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Richard Peach is a senior vice president in the Research and Statistics Group of the Federal Reserve Bank of New York.
Robert Rich is an assistant vice president in the Research and Statistics Group of the Federal Reserve Bank of New York.
Source: Bloomberg’s Chart of the Day, Federal Housing Finance Agency Here is something I never would have guessed at, via Dave Wilson of Bloomberg: If you want to be hedged against the risk of a pickup in inflation, you would be better off buying houses than gold. That’s according to Michael Hartnett, chief…Read More
Japanese Inflation Expectations, Revisited
Benjamin R. Mandel and Geoffrey Barnes
Liberty Street Economics April 22, 2013
An important measure of success for monetary policy is a central bank’s ability to anchor inflation expectations; inflation expectations influence actual inflation and, hence, the achievement of a given inflation goal. This notion has special significance for Japan, where CPI inflation has been intermittently negative since 1994 and where it is widely believed that expectationsof future inflation have been persistently negative (that is, ongoing deflation is expected). In this post, we describe and evaluate an alternative, market-based measure of Japanese inflation expectations based on international price parity conditions. We find that recent inflation expectations have attained a level substantially higher than their previous peaks over the past three years.
By way of background, recent policy action by the Bank of Japan has shone a spotlight on Japanese inflation expectations. On April 4, the Bank announced a program called Quantitative and Qualitative Monetary Easing (QQE), which was a pledge to drastically ramp up asset purchases to increase the monetary base, and to extend the duration of assets held on the Bank’s balance sheet. Since nominal yields on Japanese government bonds have been quite low for some time, a preferred indicator of QQE’s success would be a decline in real interest rates as inflation expectations move closer to the Bank’s recently announced 2 percent price stability target.
How does one go about measuring Japanese inflation expectations? The consensus on this topic is that there is no single reliable measure. A commonly used market-based gauge of U.S. inflation expectations is the difference in yield between nominal and Treasury inflation-protected securities (TIPS)—the breakeven inflation rate. Analogous measures come from over-the-counter derivatives called inflation swaps. In Japan, the market for inflation-protected government bonds, called JGBi’s, is very thinly traded and a majority of the issuance has been bought back by the Ministry of Finance in recent years. These factors have cast doubt on the ability of JGBi prices to convey reliable information about inflation expectations. Swaps suffer from similar liquidity issues.
Alternative extant measures of inflation expectations are available from surveys of households, investors, and professional forecasters. However, survey responses may by formed in a backward-looking manner, making them more responsive to actual inflation than predictive of the future. The range of views offered by market‑ and survey-based measures is illustrated in the chart below. While measures of five- and ten-year expectations have converged somewhere around 1 percent in recent months, in the past analysts would have little confidence of even getting the correct sign of expected inflation by looking at any given measure.
Forecasting Inflation? Target the Middle
Brent Meyer, Guhan Venkatu, and Saeed Zaman
The Median CPI is well-known as an accurate predictor of future inflation. But it’s just one of many possible trimmed-mean inflation measures. Recent research compares these types of measures to see which tracks future inflation best. Not only does the Median CPI outperform other trims in predicting CPI inflation, it also does a better job of predicting PCE inflation, the FOMC’s preferred measure, than the core PCE.
At the end of 2012, the Federal Open Market Committee (FOMC) adopted a new guideline for determining when it would consider raising interest rates. What is different about the guideline is that it gives specific thresholds for various economic indicators, which if reached, would signal a change in the Committee’s interest-rate target. These thresholds were spelled out in the meeting statement: “…the Committee…currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6 1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
While the unemployment-rate threshold is expressed in terms of current conditions, the inflation threshold is in terms of the outlook for inflation. By specifying the inflation threshold in terms of its forecasted values, the FOMC will still be able to “look through” transitory price changes, like they did, for example, when energy prices spiked in 2008. At that time, the year-over-year growth rate in the Consumer Price Index (CPI) jumped up above 5.0 percent but subsequently plummeted below zero a year later when the bottom fell out on energy prices. At the time, the Committee maintained the federal funds rate target at 2.0 percent, choosing not to react to the energy price spike. Under the explicit inflation threshold, the Committee will not lose its ability to remain forward looking, and will rely on forecasts of inflation.
To help inform those inflation projections, Chairman Bernanke, in a recent press conference, stated that the Committee “will consider a variety of indicators, including measures such as median, trimmed mean, and core inflation; the views of outside forecasters; and the predictions of econometric and statistical models of inflation.” In this Economic Commentary, we highlight the usefulness of trimmed-mean measures (chiefly, the median CPI) in gauging the underlying inflation trend and forecasting future inflation.
Drilling Down to the “Core”
Perhaps the most well-known underlying inflation measure is the “core” Consumer Price Index (CPI).1 This measure excludes the prices of food and energy items because those were the two most volatile categories when the core CPI was conceived. While energy remains the most volatile broad category, food prices have become much less volatile in recent years.
Labor Slack Points to Structural Employment Problem click for larger chart Source: Bloomberg > Nice chart today from Bloomberg Briefs suggesting that we have structural problems in the labor market post-credit crisis. The income gap based on education levels is well established; there is also a low-wage bias in the economy – we seem…Read More
Source: WSJ I wanted to take a moment out this morning to briefly discuss the differences between real, nominal, after tax, and total returns: Why is it that nearly any chart that gets posted — be it index, stock, bond or commodity — invariably results in a knee jerk demand for an inflation…Read More
DJIA – Dow Jones Industrial Average (index) pre- and post- Gold Click for full chart Source: Peter Williams, Advisor Perspectives Interesting look at long term Dow but using the Gold Standard as a dividing line. To be blunt, I am really not sure what to make of it. Was going off of the Gold Standard inevitable, and therefore unimportant? Or was…Read More
I cringe each time I hear some inflationista — you may have met that guy who insisted there was no inflation during the 2000s as the dollar plunged 41% but now sees inflation everywhere — brings today up the Weimar Republic every chance he gets. Here is a look at long term Inflation we spoke…Read More
Happy anniversary Helicopter Ben! It was 10 years ago today that Mr. Bernanke gave his speech titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here” as at the time some “expressed concern that we may soon face a new problem, the danger of deflation or falling prices” as reported inflation rates were low at the time…Read More