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September 04, 2015
5-Year Deflation Probability Moves Off Zero
Since 2010, our Bank has regularly posted 5-year deflation probabilities derived from prices of Treasury Inflation-Protected Securities (TIPS) on our Deflation Probabilities web page. Each deflation probability, which measures the likelihood of a decline in the Consumer Price Index over a fixed five-year window, is estimated by comparing the price of a recently issued 5-year TIPS with a 10-year TIPS issued about five years earlier. Because the 5-year TIPS has more "deflation protection" than the 10-year TIPS, the implied deflation probability rises when the 5-year TIPS becomes more valuable relative to the 10-year TIPS. (See this macroblog post for a more detailed explanation, or this appendix with the mathematical details.)
From early September 2013 to the first week of August 2015, the five-year deflation probability estimated with the most recently issued 5-year TIPS was identically 0 as the chart shows.
Of course, we should not interpret this long period of zero probability of deflation too literally. It could easily be the case that the "true" deflation probability was slightly above zero but that confounding factors—such as differences in the coupon rates, maturity dates, or liquidity of the TIPS issues—prevented the model from detecting it.
Since August 11, however, the deflation probability has had its own "liftoff" of sorts, fluctuating between 0.0 and 1.3 percent over the 16-day period ending August 26 before rising steadily to 4.1 percent on September 2. Of course, this rise off zero could be temporary, as it proved to be in the summer of 2013.
How seriously should we take this recent liftoff? We can look at options prices on Consumer Price Index inflation (inflation caps and floors) to get a full probability distribution for future inflation; see this published article by economists Yuriy Kitsul and Jonathan Wright or a nontechnical summary in this New York Times article. An alternative is simply to ask professional forecasters for their subjective probabilities of inflation falling within various ranges like "1.0 to 1.4 percent," "1.5 to 1.9 percent," and so forth. The Philly Fed's Survey of Professional Forecasters does just this, with the chart below showing probabilities of low inflation for the Consumer Price Index excluding food and energy (core CPI) from each of the August surveys since 2007.
Although the price index, and the horizon for the inflation outcome, differs from the TIPS-based deflation probability, we see that the shape of the curves is broadly similar to the one shown in the first chart. In the most recent survey, the probability that next year's core CPI inflation rate will be low was small and not particularly elevated relative to recent history. However, the deadline date for this survey was August 11, before liftoff in either the TIPS-based deflation probability or the recent volatility in global financial markets. So stay tuned.
August 10, 2012
Deflation Probabilities on Our Radar Screen
In the latest Wall Street Journal Economic Forecasting Survey, conducted August 3–6, economists were asked whether they "expect[ed] the Fed to start another round of large-scale bond buying in 2012?" Sixty-three percent answered yes, and 49 percent expected a program would be announced in September, presumably at the end of the next meeting of the Federal Open Market Committee (FOMC) on September 12–13. Obviously this question is of interest to more than just business economists. For example, at his July 17 testimony before the Senate Committee on Banking, Housing, and Urban Affairs, Sen. Mike Crapo asked Fed Chairman Ben Bernanke whether the FOMC should seriously consider more quantitative easing going forward. As part of his response, the Chairman said that "we would certainly want to react against any increase in deflation risk." The entire video exchange can be viewed at the 52–55 minute mark here.
As part of the Atlanta Fed's Inflation Project, we regularly update probabilities of deflation in the Consumer Price Index (CPI) estimated from Treasury Inflation-Protected Securities (TIPS) prices, described here and here. The basic idea is that a recently issued 5-year TIPS has less "deflation protection" than a 10-year TIPS maturing about the same date as the 5-year TIPS. The yield spread between the 5-year TIPS and 10-year TIPS can be used to help estimate the probability of deflation.
The most recent (August 8) estimate puts the 5-year probability of deflation from early 2012 to early 2017 at around 15 percent. As seen in the figure below this probability is up slightly from May, but only about half the readings of the 5-year (2010–15) deflation probability seen in the late summer and early fall of 2010 and considerably below readings seen during the height of the financial crisis in late 2008 and early 2009.
It is important to note that these deflation probabilities are estimates based on a relatively simple model that uses a number of assumptions that not everyone may agree on. Jens Christensen, Jose Lopez, and Glenn Rudebusch at the Federal Reserve Bank of San Francisco have built an alternative model for estimating deflation probabilities that also uses TIPS yields. At the time of the publication of their paper in 2011, their model's probabilities were somewhat lower than—but highly correlated with—ours.
The TIPS market has a number of features that make inferring both inflation expectations and deflation probabilities from them tricky. Most notably, there are unknown liquidity differences between TIPS and nominal Treasury securities. A more direct way of estimating deflation probabilities—or in fact the entire probability distribution of future CPI inflation—using so-called inflation caps and floors has recently been explored by economists Yuriy Kitsul and Jonathan Wright. Inflation caps and floors are essentially options on the Consumer Price Index. We used the Kitsul and Wright method for constructing the implied probabilities of (annualized) CPI inflation over the next five years. As seen in the figure below, this method implies a 13 percent probability that inflation will be 0 percent or negative on average over the next five years. This probability is about at the midpoint of the range that prevailed between October 2009 and March 2012. (See figure 3, on page 29 of Kitsul and Wright's working paper.)
As Kitsul and Wright explain, the market for inflation caps and floors is still quite small relative to the TIPS market. So the deflation probabilities from their model should be considered suggestive, as should our own.
What's the takeaway from all this? Well, readings from the financial market indicate the likelihood of a sustained deflation is currently about 15 percent, or a bit less. That's up from earlier in the year, but not nearly as high as in 2010.
Should we be concerned about the prospect for deflation in the years ahead? This is obviously an important policy question. But I'm not a policymaker; I merely put up the numbers for you to consider. And, of course, we will continue to follow these indicators closely—as can you. Our deflation probability estimates are updated every Thursday and posted on our Inflation Project.
By Patrick Higgins, an economist in the Atlanta Fed's research department
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May 17, 2012
Is inflation targeting really dead?
Harvard's Jeffrey Frankel (hat tip, Mark Thoma) is the latest econ-blogger to cast an admiring gaze in the direction of nominal gross domestic product (GDP) targeting. Frankel's post is titled "The Death of Inflation Targeting," and the demise apparently includes the notion of "flexible targeting." The obituary is somewhat ironic in that at least some of us believe that the U.S. central bank has recently taken a big step in the direction of institutionalizing flexible inflation targeting. Frankel, nonetheless, makes a case for nominal GDP targeting:
"One candidate to succeed IT [inflation targeting] as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980's, since it did not share the latter's vulnerability to so-called velocity shocks.
"Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand—the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway."
That's certainly true, but a nominal GDP target is consistent with a stable inflation or price-level objective only if potential GDP growth is itself stable. Perhaps the argument is that plausible variations in potential GDP are not large enough or persistent enough to be of much concern. But that notion just begs the core question of whether the current output gap is big or small. At least for me, uncertainty about where GDP is relative to its potential remains the key to whether policy should be more or less aggressive.
In another recent blog item (also with a pointer from Mark Thoma), Simon Wren-Lewis offers the opinion that acknowledging uncertainty about size of the output gap actually argues in favor of being "less cautious" about taking an aggressive policy course. The basic idea is familiar. It is a simple matter to raise rates should the Fed overestimate the magnitude of the output gap. But with the short-term policy rates already at zero, it is not so easy to go in the opposite direction should we underestimate the gap.
No argument there. As I pointed out in a May 3 macroblog item, Atlanta Fed President Dennis Lockhart has said the same thing. But, as I argued in that post, this point of view is only half the story. Though I agree that the costs are asymmetric to the downside with respect to the FOMC's employment and growth mandate, they look to me to be asymmetric to the upside with respect to the price stability mandate. And I view with some suspicion the claim that we know how to easily manage policy that turns out to be too aggressive after the fact.
My issues are not merely academic. In an important paper published a decade ago, Anasthsios Orphanides made this assertion:
"Despite the best of intentions, the activist management of the economy during the 1960s and 1970s did not deliver the desired macroeconomic outcomes. Following a brief period of success in achieving reasonable price stability with full employment, starting with the end of 1965 and continuing through the 1970s, the small upward drift in prices that so concerned Burns several years earlier gave way to the Great Inﬂation. Amazingly, during much of this period, specifically from February 1970 to January 1977, Arthur Burns, who so opposed policies fostering inﬂation, served as Chairman of the Federal Reserve. How then is this macroeconomic policy failure to be explained? And how can such failures be avoided in the future?...
"The likely policy lapse leading to the Great Inﬂation …can be simply identified. It was due to the overconfidence with which policymakers believed they could ascertain in real-time the current state of the economy relative to its potential. The willingness to recognize the limitations of our knowledge and lower our stabilization objectives accordingly would be essential if we are to avert such policy disasters in the future."
With this historical observation in hand, it seems a short leap to turn Wren-Lewis's thought experiment on its head. Arguably, the last several years have demonstrated that nonconventional policy actions have been quite successful at short-circuiting the disinflationary spirals that pose the central downside risk when interest rates are near zero. (If you can tolerate a little math, a good exposition of both theory and evidence is provided by Roger Farmer.)
On the opposite side of the ledger, we know little about the conditions that would cause the Fed to lose credibility with respect to its commitment to its inflation goals, and very little about the triggers that would cause inflation expectations to become unanchored. Thus, I think it not difficult to construct a plausible argument about the risks of being wrong about the output gap that is exact opposite of the Wren-Lewis conclusion.
I end up about where I did in my previous post. Flexible inflation targeting, implemented in such a way that the 2 percent long-run inflation target rate exerts an observable gravitational pull over the medium term, feels about right to me. Despite what Frankel seems to believe, I think that idea is far from dead.
By Dave Altig, executive vice president and research director at the Atlanta Fed
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March 23, 2012
Why we debate
It's been a while since we featured one of my favorite charts—a "bubble graph" comparing average monthly job changes during this recovery with average changes during the previous recovery, sector by sector.
If you try, it isn't too hard to see in this chart a picture of a labor market that is very close to "normalized," excepting a few sectors that are experiencing longer-term structural issues. First, most sectors—that is, most of the bubbles in the chart—lie above the horizontal zero axis, meaning that they are now in positive growth territory for this recovery. Second, most sector bubbles are aligning along the 45-degree line, meaning jobs in these areas are expanding (or in the case of the information sector, contracting) at about the same pace as they were before the "Great Recession." Third, the exceptions are exactly what we would expect—employment in the construction, financial activities, and government sectors continues to fall, and the manufacturing sector (a job-shedder for quite some time) is growing slightly.
For the skeptics, I below offer a familiar chart, which traces the level of total employment pre- and post-December 2009, compared with the average path of pre- and post-recession employment for the previous five downturns:
We are now more than 16 quarters past the beginning of the recession that began in the fourth quarter of 2007, and total employment is still 4 percent lower than it was at the beginning of the downturn. In the previous five recessions by the time 16 quarters had passed, employment had increased by about 6 percent. Even in the worst case, indicated by the lower edge of the gray shaded area, employment growth was flat—and that observation is qualified by the fact that the recovery from the 1980 recession was interrupted by the 1981–82 recession.
This unhappy comparison is not driven by the construction, financial activities, and government sectors. In the area of professional and business services, which has logged the largest average monthly employment gains in the current recovery, the number of jobs still sits 2.7 percent below the level at the outset of the last recession, as the chart below shows.
Total private-sector jobs in education and health services, which never actually contracted during the recession, nonetheless remain abnormally low in historical context.
In these charts lies the crux of some very basic disagreements about the appropriate course of policy. The last three graphs draw a clear picture of labor markets that are underperforming by historical standards—a position that I take to be the conventional wisdom. An argument against following that conventional wisdom centers on the question of whether historical standards represent the appropriate yardstick today. In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.
One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious. Measured inflation appears to moving in the direction of the Federal Open Market Committee's 2 percent long-term objective.
Also, the Atlanta Fed's own monthly survey of business inflation expectations, which surveys a panel of businesses from our Reserve Bank district, indicates that this inflation number (shown in our March release from earlier this week) is in line with what private-sector decision makers anticipate:
"Survey respondents indicated that, on average, they expect unit costs to rise 2.0 percent over the next 12 months. That number is up from 1.9 percent in February and comparable to recent year-ahead inflation forecasts of private economists. Firms also reported that their unit costs had risen 1.8 percent compared to this time last year, which is unchanged from their assessment in February. Inflation uncertainty, as measured by the average respondent's variance, declined from 2.8 percent in February to 2.4 percent in March, the lowest variance since the survey was launched in October 2011."
Does that settle it? Not quite. There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn't over yet.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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June 13, 2011
Core cuts both ways
With the six-month average of annualized headline inflation running just over 5 percent, this Wednesday's consumer price index (CPI) report looms a little larger than usual. While it is dangerous to predict such things, there is every reason to believe that the measured increase in CPI inflation for May could be quite low. And there is every reason to believe that this softness will persist into June.
The reason is quite simple. Movements in gasoline and fuel prices really do push around the headline inflation number, and at long last it looks like that movement is in the downward direction. Here's the relevant picture:
Let's assume that, annualized, CPI excluding food and energy rises 2.1 percent, as it has so far this year, and food and nongasoline energy prices each rise at 5 percent. Then when you plug in gasoline prices already realized for May and EIA predictions for June, you get a 0.4 percent rise in the headline CPI in May and a 0.7 percent decline in June (both rates annualized).
Despite some probable relief on the headline inflation number, I remain aware of what that relief means and what it does not. Earlier in the year, Atlanta Fed president Dennis Lockhart had this to say:
"I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services…
"… The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food or provide health care. We cannot prevent the next oil shock, or drought, or a strike somewhere—events that cause prices of certain goods to rise and change your cost of living."
Two points, then. First, even if things evolve as the chart above suggests, the level of gasoline prices will remain relatively high by recent standards. Low inflation readings for the next couple of months would therefore leave the cost-of-living high by recent standards, a fact that is not lost on us here at the Atlanta Fed.
Second, as President Lockhart's comments reveal, we were reluctant to attribute the run-up in fuel prices to monetary policy. And I imagine we will be equally reluctant to credit monetary policy with any relief from that trend.
In fact, I will fearlessly predict that, should our guess here about headline inflation in the next couple of months be proved accurate, we will point to core inflation measures as reason to look through some very low inflation readings. See these comments from President Lockhart's most recent speech for some additional perspective:
"Are the recent outsized increases in headline inflation the best signals of the inflation trend going forward? Or are other statistics—like core inflation or measures of inflation expectations—yielding a truer picture of what lies ahead?
"The answer matters a lot. And it certainly weighs heavily on my thinking. I would not hesitate to support an exit from our current policy stance if I believed that the headline inflation number of the past six months is really indicative of the underlying trend inflation rate. I don't believe this to be the case. And I am wary of tightening monetary policy in the face of quite ambiguous economic circumstances unless doing so is absolutely necessary to meet the FOMC's price stability mandate."
And here's why it matters, quoting President Lockhart from an interview with Reuters last week:
"In the interview, Lockhart said maintaining an easy Fed policy stance should ensure the moderate U.S. recovery does not fall off the rails."
"How high would the bar be for further Fed easing?
"It would take 'a significant deterioration as reflected in the overall economy, a set of deflationary signals and also unemployment numbers that rise dramatically. Last fall (when the Fed launched QE2), by some measures, we were seeing declining inflation expectations that were headed in a pretty negative direction, and that was happening pretty rapidly. We were in a disinflationary environment. So the risk of deflation was plausible. We acted and the situation has turned around. That was, at least in my way of thinking, very central to supporting the policy. We don't have anything remotely like a deflationary risk at the moment, short of a shock of some kind.' "
If what I suggest above—falling headline inflation, stable core inflation—comes to pass in the near term, don't expect me to start ringing the disinflationary bell.
This isn't the last word on the usefulness of core inflation statistics, and the debate is certain to rage on (see here and here, for recent installments). But I do hope that this post is remembered the next time the Federal Reserve is accused of hiding inflationary pressures behind the rhetoric of core.
Update: The May CPI report is in, and once again the facts trump arithmetic. We got the flip in the headline/core measures right; the rest, not so much.
Update: Here's one way to construct a synthetic CPI:
CPIHeadline(T) is the calculated value of the seasonally adjusted CPI in month T > December 2010. CPIHeadline(Dec2010) is the reported seasonally adjusted headline CPI for December 2010. CPIFood, CPICore, CPIGas, CPIOtherFuel, and CPIHHenergy are the seasonally adjusted component level CPI indexes for the above mentioned components. Note that this formula will not exactly replicate the January through April 2011 headline CPI since the components are not granular enough. When using the above formula to compute CPIHeadline(Apr11) and CPIHeadline(May11), we compute one-month headline inflation in May 2011 as the percent difference between the values of CPIHeadline(Apr11) and CPIHeadline(May11), both calculated with the above formula (i.e., do not use the reported value of CPIHeadline(Apr11)). In our calculations we used the same inflation assumptions for "other motor fuels" and "household energy" (both increase at a 5 percent annualized rate in May and June). By Patrick Higgins, an economist at the Atlanta Fed
By Dave Altig, senior vice president and research director at the Atlanta Fed
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March 07, 2011
One chasm that really isn't one
Floyd Norris, writing last Friday in the The New York Times, fretted about "The Chasm Between Consumers and the Fed." We here at the Atlanta Fed share some of that concern, and indeed the Times article quotes from a speech by our president Dennis Lockhart on just that subject from last month. But then Norris takes a turn I didn't expect. Norris's Times article includes the following chart…
…and the article proceeds:
"The Fed's goal is to keep the inflation rate at or near 2 percent, and it does not expect a significant increase for at least a few years. … The stock market is generally thought to do better when inflation is falling, but Martin Fridson, the global credit strategist for BNP Paribas Investment Partners, points out that is not always the case. There is, he says, a time when inflation is too low.
"The accompanying chart, based on a report by Mr. Fridson, shows that from the 1940s through the 1990s, there generally was a relationship. The more inflation declined in a decade from inflation in the previous decade, the better the stock market did.
"But in two decades, the 1930s and the first decade of this century, inflation fell from already low levels and the stock market suffered. 'Below a certain level of inflation,' Mr. Fridson said, 'a further decline reflects economic weakness more than it reflects a salutary reining in of excessive monetary creation.'
"If that is correct, then it could be that both investors and those simply concerned with promoting economic growth should, as Mr. Fridson wrote, hope that Mr. Bernanke 'fails in his stated goal of holding inflation to 2 percent or less.' "
It was all good, up to that last paragraph. As President Lockhart reiterated in a speech today (emphasis added):
"I'll explain the technical rationale of my Reserve Bank in supporting the scope of LSAP2 [the second round of large-scale asset purchases] last November.
"Through the summer and into the fall of last year, our internal forecasts at the Atlanta Fed were calling into question whether the policy stance at the time assured progress toward the committee's growth and price stability objectives. In more normal times, these circumstances would have prompted a cut in the FOMC's [Federal Open Market Committee] target for the federal funds rate. This approach would be (would have been) the prescription of the so-called Taylor rule which relates policy rate moves to forecast 'misses' on the Fed's sustainable growth and stable inflation objectives."
As we've argued in macroblog before, keeping inflation from falling below that "certain level of inflation" reflecting "economic weakness more than it reflects a salutary reining in of excessive monetary creation" was exactly what President Lockhart has offered in defense of implementing LSAP2, and in support of claims to its success.
There remain plenty of policy questions on which intelligent well-intentioned folk can disagree, but on the assertion that it is wise to guard against too much disinflation, we are in agreement. No need to find disagreements that aren't really there.
By Dave Altig
Senior vice president and research director at the Atlanta Fed
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December 22, 2010
An inflation (or lack thereof) chart show
Over at TheMoneyIllusion, Scott Sumner takes a shot at what he refers to as "Disinflation Denial." His point is that prior to the recent run-up, "commodity price indices fell by more than 50%." Thus, if the run-up in commodity prices suggests loose policy now, they must have been signaling tight policy earlier.
I am hesitant to endorse the view that any subset of prices gives us a clear view of inflation trends. What I do endorse in the Sumner piece is the advice that "the Fed look at a wide range of indicators." I can tell you that is exactly what we do at the Atlanta Reserve Bank and, as just one example within the Fed System, in this post I'll review the battery of indicators that we are currently looking at here. Most of these will be no surprise, but I find it useful to occasionally see them in one place. So here we go. (Note that throughout this blog post I will focus most of my comments on the consumer price index [CPI], but most of what I say also applies to the personal consumption expenditure [PCE] price index as well.)
First up, of course, are the so-called (and often maligned) core measures of inflation. I am completely sympathetic to the view that the traditional core index, which subtracts out food and energy components, is a somewhat arbitrary cut of the price statistics. For that reason, Ipersonally tend to lean more heavily on median and trimmed-mean measures.
In Atlanta, we have been monitoring a newer core inflation measure, called the "sticky-price CPI," jointly developed by Mike Bryan and Brent Meyer (of the Atlanta and Cleveland Feds, respectively). As described by Bryan and Meyer:
"Some of the items that make up the Consumer Price Index change prices frequently, while others are slow to change… sticky prices [those that are slow to change] appear to incorporate expectations about future inflation to a greater degree than prices that change on a frequent basis… our sticky-price measure seems to contain a component of inflation expectations, and that component may be useful when trying to gauge where inflation is heading."
Like the other core measure, the sticky-price CPI shows a pronounced downward movement over the past several years, with some sign of (an ever-so-slight) recovery as of late.
Though I disagree with the assertion that core measures are a convenient way to ignore unpleasant movements in the overall CPI—there is evidence that core measures are useful in predicting where total CPI inflation is heading—it is almost surely a bad idea to ignore what is happening to headline statistics. (After all, in the end it is the average of all prices with which we are concerned.)
Here too, the evidence suggests, at the very least, there is scant evidence that disinflation has left the scene:
I find it useful to take at least two more cuts at the overall price data. One, which has a decidedly short-term focus, involves examining the distribution of price changes in the broad categories that make up the headline CPI. Though a popular criticism of Fed policy—discussed and critiqued at Econbrowser—tries to deflate deflation concerns by reciting a number of prices that are rising, it is obvious that one could just as easily tick off a reasonably large list of prices that are falling:
(The individual colors in the chart represent different components of the CPI. The underlying data can be found from this link to the explanation of the median CPI.)
The graph of the November price change distribution is actually somewhat encouraging. What it tells us is that almost half of the price changes in the CPI market basket, weighted by their shares of total consumer expenditures, fell in the (annualized) range of 0 percent to 2 percent. Furthermore, about as many price changes were below this range as they were above it.
A closer look at the prices that fall in the 0 percent to 2 percent category, however, reveals that individual price changes are skewed to the downside of the range:
On a month-to-month basis, the distribution of individual prices does shift around, so these statistics are nothing more than suggestive short-run snapshots (but I believe they are informative nonetheless).
At the other end of the temporal scale is a look at how inflation has behaved over time. If the central bank had a long history of missing its stated inflation objectives, we might feel very different about an inflation rate that is below what Chairman Bernanke has referred to as "the mandate-consistent inflation rate" of "about 2 percent or a bit below" than we would if average prices were hewing pretty close to the target path. As I have previously noted, over the past 15 years or so, the Federal Open Market Committee (FOMC) has delivered an average inflation rate, measured as growth in the PCE price index, that is wholly consistent with this mandate. Here's the case in a graph, adjusting the mandate-consistent inflation rate to account for an assumed upward bias in the CPI relative to the PCE index:
Actually, those short-run complications are mostly associated with falling expectations of inflation. In my last macroblog post, I argued that the stabilization of market-based CPI inflation expectations and the associated decline in the perceived probability of deflation should arguably be counted as a success of the Fed's current policy stance. The latest on market-based expectations was included in our previous macroblog item. For completeness, survey-based expected long-term inflation remains somewhat below the levels prior to the onset of the recession:
I believe this is basically the bottom line: whether we look at headline inflation (straight-up, component-by-component, or in terms of the long-run trend), core inflation measures (of virtually any sensible variety), or inflation expectations (survey or market based), there is little a hint of building inflationary pressure.
While I don't dismiss the usefulness of looking at other indicators (stock prices, bond prices, foreign exchange rates, commodity prices, and real estate prices are on Scott Sumner's list; I would add various measures of labor costs to mine), you have to be pretty selective in your attentions to build the contrary case.
But feel free. We'll keep watching.
By Dave Altig
Senior vice president and research director at the Atlanta Fed
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December 17, 2010
What's behind the recent rise in Treasury yields?
David Beckworth, who blogs at Macro and Other Market Musings, posted a comment regarding macroblog's post "What might monetary policy success look like?" from December 2. Beckworth's comment specifically mentioned this chart…
… as part of this question:
"How did you create the latter figure [shown above]? Using the Fed's own constant maturities series (for both the nominal and real yield), the figure I come up with is less impressive. It shows a turnaround in inflation expectations about the time QE2 is promoted by Fed officials, but then inflation expectations stall and remain far from the 'mandate-consistent inflation rate.'
"Here is a post where I placed one such graph."
And here's the graph of expected inflation from Beckworth's post:
The series shown in the Beckworth chart has a different economic meaning than the chart shown in the original macroblog post (as was suggested by another commentator to our earlier post).
The chart Beckworth shows in his referenced blog post is the five-year Treasury Inflation-Protected Securities (TIPS) spread (the difference in nominal and real Treasury yields at five-year maturities). And so when he states, "This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November" it means just that: it's examining the next five-year period (2010–15). I've reposted below an updated version of this chart, along with the 10-year TIPS spread. Since Beckworth's comment on macroblog, the five-year TIPS spread has widened about 13 basis points, depending on the measure you're using.
The chart used in the December 2 macroblog post is a different measure altogether. It's the five-year/five-year forward break-even inflation rate—not the TIPS spread. This chart shows a measure of expected inflation in the five-year period beginning five years from now. So this chart shows what investors expect to be the cumulative change in the consumer price index beginning in November 2015 through November 2020. Put another way, it's the realized inflation that would provide an equivalent return to both the nominal Treasury securities and the real TIPS securities. An updated picture is provided below.
Thus we're talking about apples and oranges in two respects: (1) these two charts cover different periods (2010–15 versus 2015–20); and (2) the two calculations themselves are different (taking a simple nominal-real spread versus the 5-year/5-year forward calculation).
Now what's the point of all of this, besides highlighting the minutiae of measuring inflation expectations? Resurrecting Beckworth's question and answering it help illuminate the recent concern about increases in Treasury yields. Indeed, since the November Federal Open Market Committee (FOMC) meeting, longer-dated yields have risen considerably, with the 10-year bond's yield up 86 basis points, for example. But the recent movements in nominal and real yields can be placed in two categories: (A) from when the Federal Reserve began signaling consideration of further asset purchases (late August) to the November FOMC meeting, and (B) the post-November FOMC meeting period. In period A, nominal yields were relatively flat while real yields declined somewhat, indicating a healthy rise in inflation expectations from the lows seen this summer (this change is shown by the increase in the TIPS spreads and breakeven inflation rates during the period). In period B, the rise in nominal yields has been primarily driven by a rise in real yields (not unanchored inflation expectations).
As Martin Wolf wrote in Tuesday's Financial Times on this issue, "To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations." As is evident in the charts, and in one of Beckworth's most recent posts, real rates have risen alongside nominal rates—a sign that inflation expectations are now relatively stable.
By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department
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December 02, 2010
What might monetary policy success look like?
As 2010 nears its end, my colleagues and I are beginning the process, familiar to organizations public and private, of evaluating performance in the past year and setting goals for the year ahead. In that process, one question is pressed: What does success look like?
It is a good question for monetary policy, and one I touched on a couple of posts back. As in that post, I'll cite my boss, Atlanta Fed President Dennis Lockhart from his Nov. 16 speech in Montgomery, Ala.:
"In my mind, the perceived risks—particularly the risk of overshooting inflation—must be weighed against the risks that could be associated with a policy of inaction. Chief among those risks is a recessionary relapse possibly tipping into a long spell of deflation. Through the summer there were some signs of renewed disinflation, which could lead to deflationary expectations taking hold.
"I think it is important to stress that our experience in dealing with inflation versus deflation is not symmetric. In the event of a policy overshoot, inflation containment requires the implementation of the mostly familiar strategy of raising short-term interest rates. In the event of an undershoot, however, dealing with a deflationary spiral and the attendant real consequences would be far less familiar territory for policymakers."
So, in President Lockhart's view, there is the statement of objective—insurance against an unwanted deflationary spiral. And the measure of success? Again from President Lockhart, as quoted in my previous post:
"In regard to price stability, this policy has already shown some signs of success by altering inflation expectations and reducing the risk of unwanted disinflation. To explain, inflation expectations extracted from Treasury inflation-protected securities, or TIPS, spreads over like-duration Treasury securities were declining persistently over the course of late spring through summer.
"Following the August 27 Jackson Hole speech by Fed Chairman Ben Bernanke, these spreads have recovered to previous levels. In addition, according to analysis we've done at the Atlanta Fed, deflation probabilities reflected in TIPS have fallen from the high levels prior to the September FOMC meeting."
Those deflation probabilities were described in an earlier macroblog post, and if you are looking for a measure of success, here is a picture:
As of today's update, these probabilities have fallen to the levels observed prior to the economy's summer soft patch. Importantly, the deflation probabilities have retreated without a movement of straight inflation expectations outside of bounds that are (arguably) consistent with what Chairman Bernanke has described as "the mandate-consistent inflation rate."
Of course, the full story has yet to be written. But it looks like a promising start to me.
Note: The deflation probabilities mentioned in the blog are published weekly as part of the Atlanta Fed's Inflation Project. For a description of inflation expectations, measured as the breakeven rates calculated from TIPS yields, see this article from the Federal Reserve Bank of San Francisco.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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July 09, 2010
How close to deflation are we? Perhaps just a little closer than you thought
Since last October, the consumer price index (CPI) has gone up an annualized 0.7 percent. On an ex-food and energy basis, the number is a little lower, at 0.5 percent. And the Cleveland Fed's trimmed-mean and median CPIs, at 0.7 percent and 0.2 percent, respectively, also put the recent trend in consumer prices in pretty low territory.
And this is before we take into account any potential mismeasurement, or "bias," in the construction of the CPI.
How big is the CPI's bias? Well, in 1996, the Social Security Administration commissioned a study on the accuracy of the CPI as a measure of the cost of living. This so-called "Boskin Commission Report" said the CPI was overstated by about 1.1 percentage points per year. The commission identified several sources of potential bias, but about half of the 1.1 percentage points resulted from new products and quality changes that were slow or otherwise imperfectly introduced into the price statistic.
Since that time, the Bureau of Labor Statistics has initiated a number of methodological changes that have reduced the CPI's mismeasurement. In a 2001 paper, Federal Reserve Board economists David Lebow and Jeremy Rudd put the CPI bias at only about 0.6 percentage points. And again, of this amount, the big share of the bias (about 0.4 percentage points) resulted from the imperfect accounting of new and improved goods.
Now, in an article (available to all in its working paper version) appearing in the latest issue of the American Economic Review, Christian Broda and David Weinstein say the earlier estimates of the new goods/quality bias may be a bit understated. The authors examine prices from the AC Nielsen Homescan database and conclude that between 1996 and 2003, new and improved goods biased the CPI, on average, by about 0.8 percentage points per year. If this estimate is accurate, consumer price increases since last October would actually be around zero, or even slightly negative, once we account for the mismeasurement of the CPI caused by new and improved goods.
But (oh, you just knew there was going to be a "but" in here, right?) the authors also point out that, because new goods are introduced procyclically, this bias tends to be larger during expansions and smaller during recessions. In other words, given the severity of the recession and the modest pace of the recovery, there may not be a whole lot of innovation going on right now in consumer goods. This is a bad thing for consumers, of course, but it would be a good thing for the accuracy of the CPI.
By Mike Bryan, vice president and senior economist at the Atlanta Fed
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