Posts filed under “Inflation”

Expectations Stay Anchored in Spite of Declining Inflation

Expectations Stay Anchored in Spite of Declining Inflation

Charles T. Carlstrom and Margaret Jacobson

The Federal Open Market Committee (FOMC) has stated that its long-run target for inflation is 2 percent. Inflation does and will always vary around that target, but some observers are worried that the recent decline we have seen in inflation is especially troublesome because the federal funds rate is essentially zero.

The worry is that with what is basically the economy’s short-term interest rate at zero, declines in inflation will cause one-for-one increases in the real interest rate (the after-inflation cost of borrowing). As a result, a decrease in economic activity could push down prices, and real economic activity could suffer because of the increase in real interest rates.

Though we have only limited information to go on, the decline in inflation is not likely to continue. While short-term inflation expectations have declined somewhat with the recent declines in inflation, longer-term inflation expectations have not drifted down to any meaningful extent, which should help mute ongoing declines in inflation.

Personal Consumption Expenditures (PCE) inflation was essentially zero in the fourth quarter of 2013, significantly under the FOMC’s target. Throughout 2013, PCE inflation averaged about 1.0 percent, still below the 2 percent target. Meanwhile, core PCE inflation, which excludes the volatile energy and food components, averaged 1.1 percent for the first two months of the fourth quarter and over 2013 as well. While the FOMC is concerned about PCE inflation as a gauge of price stability, core PCE inflation is closely watched because there is some evidence that it predicts inflation over longer horizons better than total inflation.

Although the FOMC focuses on the PCE, the Consumer Price Index provides another useful measure of inflation. The CPI is constructed from the prices faced by the average consumer, and CPI inflation typically runs about 25 basis points higher than PCE inflation. The overall pattern in recent CPI inflation is quite similar to PCE inflation. CPI inflation in the fourth quarter was 0.9 percent, and core CPI inflation was approximately 1.6 percent. This is also what core CPI inflation averaged over the past year, though in the previous two years it averaged between 1.9 percent and 2.2 percent. Therefore, it too has shown a continual decline over the past two years.

An interesting feature of both PCE and CPI inflation is the difference between the behaviors of inflation for service prices and goods prices. While the FOMC’s objective is for total inflation, some people are particularly concerned about the dramatic decline in goods prices. For example, PCE core-goods-price inflation has been falling steadily, dropping from 1 percent in 2011 to −0.7 percent in 2013, while inflation in core PCE service prices has been almost perfectly flat for three years, hovering around 2 percent.

We see the same pattern with the CPI. Core service inflation has been nearly steady for two years at a tad above 2 percent. But over that time, core goods inflation fell sharply, dropping from an increase of 2.2 percent in 2011 to a decrease of 0.1 percent in 2013.

The decline in core goods inflation would be troublesome if core goods inflation predicted future inflation better than either core service or total core inflation. But arguably this is not the case. PCE service inflation is a better predictor of future inflation than goods inflation, while the evidence is mixed for the CPI. In the end, core (total) inflation is as good a predictor of both PCE or CPI inflation as goods or services inflation.

Inflation Correlations, Quarters Ahead

Predictor PCE Predictor CPI
One quarter ahead Four quarters ahead One quarter ahead Four quarters ahead
Core PCE 0.81 0.65 Core CPI 0.73 0.55
Core PCE goods 0.74 0.57 Core CPI commodoties 0.69 0.53
Core PCE services 0.78 0.65 Core CPI services 0.68 0.52

Note: Correlations are calculated from 1967:Q2 to 2013:Q3.
Souces: Bureau of Labor Statistics, authors’ calculations.

Another way of gauging whether or not the recent declines in inflation are a problem is to look at the long-term inflation outlooks of Blue Chip forecasters. Although their forecasts for near-term inflation have fallen a bit, the decrease seems to be transitory. While their prediction for inflation in the first quarter of 2014 is now ½ percentage point lower than they predicted in October, their forecasts for the second quarter of 2014 and onward have largely stayed the same.

Longer-term inflation forecasts, as measured through TIPS (Treasury inflation-protected securities), were basically unaffected by the FOMC’s (surprising) December decision to taper asset purchases. Both 5- and 10-year forecasted rates show an insignificant decrease of around 2 basis points.

While there is uncertainty about short-term inflation, every indication is that longer-term inflation expectations remain anchored around 2 percent.

Source: Cleveland Fed

Category: Federal Reserve, Inflation, Think Tank

Why Do Measures of Inflation Disagree?

Why Do Measures of Inflation Disagree? Yifan Cao and Adam Hale Shapiro FRBSF Economic Letter December 9, 2013     Inflation as measured by the personal consumption expenditures price index is near historical low levels, below the Federal Reserve’s 2% longer-run goal. Another common inflation measure, the consumer price index, is also historically low, but…Read More

Category: Inflation, Think Tank

Fed Deflation in One Picture

Hilarious:   Via VolSlinger

Category: Federal Reserve, Humor, Inflation

2010 Reminder: QE = Currency Debasement and Inflation

One of my biggest complaints about the media is the lack of accountability. People say things on TV in print an on radio, and then . . .  Poof!  No consequences. They influence public perception of issues, affect policy debates, drive legislation. This is a perfect example of a stern warning of currency debasement and…Read More

Category: Currency, Inflation, Really, really bad calls

How Columbus Caused Inflation

Click to enlarge Source: Economist     According to the Economist: “Some modern economic historians dispute Smith’s argument that the discovery of the Americas, by Christopher Columbus in 1492, accelerated the process of globalisation. Kevin O’Rourke and Jeffrey Williamson argued in a 2002 paper that globalisation only really began in the nineteenth century when a…Read More

Category: Inflation

Category: Inflation, Think Tank

U.S. Health Care vs. The World


click for ginormous graphic
US healthcare


Read More

Category: Digital Media, Economy, Inflation

Commodity Prices and Inflation: The Perspective of Firms

Commodity Prices and Inflation: The Perspective of Firms Mike Bryan, Brent Meyer and Nicholas Parker July 16, 2013     We’ve been thinking a lot about commodity prices lately. In case you haven’t noticed, they’ve been falling. And with inflation already tracking well under the Federal Open Market Committee’s (FOMC) longer-term objective of 2 percent,…Read More

Category: Commodities, Inflation, Think Tank

Friday Funny: Higher Prices

This is brilliant: The Federal Reserve is awaiting That prices may start re-inflating, So they can foresee Unwinding QE, Whose tapering they’ve been debating. The Fed will not bother to taper Its purchase of Treasury paper ‘Til the jobless rate now And inflation allow An end to their stimulus caper. Bernanke must act with agility…Read More

Category: Federal Reserve, Humor, Inflation

Following the Fed Out of Bonds?

Click to enlarge Source:   Excellent explanatory chart from the FT.   Source: Bond Traders Take Cue to Exit Treasuries By Michael Mackenzie and Stephen Foley FT, June 20, 2013 4:52 pm

Category: Federal Reserve, Inflation