What might we expect from inflation over the course of the next year or so, barring any exogenous shocks, such as geopolitical concerns affecting the price of oil, or natural disasters that damage crop production? Will high unemployment keep inflation down, or conversely, will the prior effects of Federal Reserve actions eventually work their way through the system to send inflation higher?
These are some questions the Dallas Fed sought to answer in a recent paper, "Inflation, Slack and Fed Credibility." Its findings: High unemployment, coupled with expectations that the Fed will be successful in controlling inflation, might result in inflation coming in at a bit less than 1.5% over the 12 months from the third quarter of 2011 to the same quarter in 2012. (Of course, there is a wide confidence interval around that estimate, so be careful not to be too precise with that forecast.) Let's take a closer look, beginning with where we are now.
This past week brought us the trio of inflation measures from the Bureau of Labor Statistics: the consumer price index (CPI), the producer price index (PPI) and the lesser-followed import and export price measures. All of them show subdued inflation, but here we'll focus on the end-cost increases to consumers.
The consumer price index in December was unchanged for the second month in a row, and lower energy costs played a key role. Excluding food and energy, the CPI, after gaining 0.2% in November, decelerated to a modest 0.1% increase. Year on year, overall CPI inflation was 3.0%, compared with 3.4% in November (seasonally adjusted). The core rate edged held steady at 2.2% on a year-over-year basis. While the year-over-year rate for core inflation is still above the Fed's target of inflation of 2% or slightly less -- noting that CPI is not the Fed's preferred inflation measure -- the trend is that inflation has been subdued, especially when looking at the core rate.
Intuitively, we can understand that it might be unlikely for inflation to rise while we have high unemployment and slack in the labor force limiting wage gains -- often the biggest source of cost pressures for many companies. But many pundits have opined that easy money from the Fed could spark higher inflation at some point. Competing schools of thought offer perhaps contradictory arguments. Some say that inflation is always a monetary phenomenon, while others point to historical evidence that inflation is inversely correlated to the unemployment rate. The true answer may be between the two, but the slack theory might hold more weight.
The Dallas Fed's research sought to quantify that answer and test those theories. It did indeed find that unemployment is a good predictor of future inflation. For each percentage point that the unemployment rate exceeds its average, trimmed mean inflation -- that is, inflation measured without extreme price movements of outliers -- can be expected to come in 0.2 percentage points below its long-run trend.
Changes in slack matter, too. Trimmed mean inflation can be expected to come in 0.1 percentage points below trend for each quarter-point increase in the unemployment rate. Thus, if we assume that the long-run average for the unemployment rate is about 6% or so (measured over the past 20 years) and that the trend rate of inflation is about 2%, and that we currently have an unemployment rate of 8.5%, then we might expect inflation to be in that 1.5% range that the Dallas Fed forecasts.
Of course, Fed policy might have an influence, so the Dallas Fed did include that in its analysis. Historically, changes in public perceptions of the Fed's long-run inflation objective have also had a strong influence on trimmed mean inflation. However, since the late 1990s, movements in these perceptions have been small and transitory, hence unimportant for forecasting. In other words, the public isn't quite as focused on the Fed's actions as it might have been in the past, when it comes to businesses setting prices and consumers' willingness to tolerate those price increases.
As such, we might then believe that the Fed conceivably could have room for an easy-money policy as long as unemployment remains elevated. And few forecasters are predicting that unemployment will come down by a meaningful degree anytime soon. That means that the Fed can shift its focus toward generating full employment, as it perhaps needs to worry less about its policies triggering inflation. We'll discuss in my upcoming "Economic First Look" column what we might expect from the FOMC meeting on Jan. 25.
In the meantime, though, inflation might continue to be subdued. The reason it is subdued, though, isn't all that reassuring. The main takeaway is that the Fed could theoretically achieve its goals of nearly full employment with inflation near its 2% target. The big question, though, which we'll discuss in tomorrow's column, is whether the Fed will actually engage in more action. And will any of those potential efforts, past, present or future, even work?