By Jim Cline
Last week, we reported the sudden drop in the National and Seattle CPI numbers and also discussed the potential impact on 2014 and 2015 negotiations. In October, we had also written about the 2% inflation target established by the Federal Reserve Bank as they use monetary policy to attempt to control inflation. We explained how the Fed seems to be falling short on those 2% goals:
Historically, over the past 20 years, inflation is around 3%. More recently, 2% inflation seems to reflect the “new normal.” Most recent economic forecasts predict 2% inflation in the next two to three years.
But now, even those projections are in further doubt. The latest revised projections of the Federal Reserve have been reduced below 2% in the near term with inflation likely to stay below 2% until 2015 or 2016. The Fed is predicting inflation for the year 2013, will be between 1.1% to 1.5%, rising to an expected “range” of 1.5% to 2% for 2014.
In a recent policy statement, the Federal Reserve Bank indicated, yet again, that its policy “target” is for 2% inflation. It stated that “recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.”
But the October inflation reports show the CPI dropping under 1%. So why does the Fed keep missing its 2% target? A recent research report issued by the Fed itself seeks to explain why. It is, they report, a reminder “of the uncertainty that always surrounds forecasts” and, they claim, their predictive model is not flawed but rather “within the normal range of certainty.”
For those who like to “dig into the weeds” of economic statistics, here’s a longer “econo speak” version of the explanation:
Many observers have been surprised by the decline in consumer price inflation that has occurred since early 2012. At that time, the Federal Open Market Committee (FOMC) projected that both overall and core PCE inflation would be about 1.7 percent in 2013. Today, though, these measures of inflation stand at about 1.2 percent. PCE inflation this year has also come in well below the projections of private-sector economists captured in the February 2012 Survey of Professional Forecasters (SPF).
Should the unanticipated fall in inflation raise doubts about the reliability of common forecasting models—such as those used at the Cleveland Fed—and projections of inflation for the period ahead? The answer to those questions depends on the magnitude of the surprise relative to historical norms and the ability of the models to explain (after the fact) the slowing of inflation. Magnitude matters because the outlook for inflation and other macroeconomic variables is always uncertain, and even though the actual path of inflation has deviated from the model forecast, it may still fall within the normal range of uncertainty around the path the model projected.
The ability of models to explain the deviation of actual inflation from the forecast matters because it reflects how well the model is constructed. Inflation may have followed a path different from the one expected because the economy experienced surprise movements in some of the determinants of inflation that are built into the model, such as GDP growth or unemployment. Assuming these determinants return to behaving as expected, the model’s forecasts will match actual inflation outcomes more closely. To the extent the model cannot attribute the deviation to movements in these determinants, we might worry about its reliability and its projections for the future.
Our results indicate that the surprising decline in inflation shouldn’t be raising doubts about model reliability and future projections of inflation. In our analysis, the gap between actual inflation and forecasts made in early 2012 falls well within the normal range of uncertainty. In addition, the model explains most of the falloff in inflation as a response to other economic developments. As a result, the unanticipated falloff in inflation should simply serve as a useful reminder of the uncertainty that always surrounds forecasts.
In other words, we make predictions but you can’t hold us to them when they don’t turn out.
When I attended graduate school at Notre Dame in the 1980s, earning a Master’s Degree in Economics jointly with my law degree, there was significant academic debate about the ability of the Fed’s monetary policy to effectively control or influence the inflation rate. Since that time, a considerable consensus among economists has developed that due to the improved knowledge and access to data and further Federal Reserve practice in setting monetary policy, the Fed can more carefully predict and control the actual inflation rate. Still, the Fed research acknowledges they are imperfect in the prediction business…
Moving forward, a more significant question is what lies ahead. Separate and apart from the fact that the Fed keeps missing its 2% target, there is significant academic and political pressure growing for the Fed to return its inflation target closer to the historic 3% range. Liberal economist Paul Krugman argued for much higher inflation targets back in 2010 as a way to stimulate the economy. Other Fed critics complain that the current stagnant labor market is a bigger concern and allowing higher inflation might stimulate the economy.
We have a new Fed Chair, Janet Yellen. While there have not been many predictions of a big shift in Fed policy due to this appointment, (Yellen was already one of the Fed Governors and they chairs are being moved around) there may be reason to think that Yellen’s more liberal political/economic views might led the Fed to reconsider its current 2% policy target. I wouldn’t expect a rapid shift affecting inflation over the next 12 months, but I wouldn’t be at all surprised to see some increase in inflation moving into 2015 and beyond.
Time will tell. But if CPI does rise, contract settlements will rise as well.
