macroblog

Private sector forecasts at variance

Economic forecasts are notoriously inaccurate. That isn't a statement about the ability of forecasters, but rather a statement about the complexity of the economy. If you're looking for a humbling experience, I recommend you give it a try.

And today's economy would seem to be an exceptionally difficult environment in which to forecast. As economists peer into the future, there seems to be an unusually wide range of opinion about what to expect. Uncertainty is running pretty high right now in the minds of the top prognosticators.

Consider the following predictions from the Blue Chip panel of economists concerning the economy's growth rate a year and a half from now (fourth quarter 2010). The average growth rate expected in that time frame from the panel is 3 percent, which isn't that different from the six-quarter-ahead forecast they have made every June during the past 10 years or so. But if you compare the difference between the economic optimists (the 10 highest growth forecasts) relative to the economic pessimists (the 10 lowest growth forecasts), the discrepancy between the two views is large relative to recent history. In short, the forecasts on the optimistic end of the spectrum are now more optimistic while the pessimistic forecasts are a little more pessimistic.

Uncertainty over the medium-term outlook is particularly large regarding the experts' views on inflation. In the latest survey of the Blue Chip panel, the difference between the 10 highest and the 10 lowest inflation predictions for the fourth quarter of 2010 was a gaping 3.7 percentage points (compared with an average of about 1.5 percentage points over the past decade and a half). This wide range of opinions about inflation prospects started to emerge last year as economic conditions deteriorated.

Disharmony in the panel's inflation outlook doesn't so much suggest that those expecting inflation now see greater inflationary risks—at 3.2 percent the medium-term inflation prediction of the highest 10 inflation forecasts isn't materially different from where it has been since the late 1990s. Instead, the larger variance in the inflation outlook is coming from those at the bottom of the panel's forecast distribution that are anticipating even more downward price pressure than in previous years.

Pinpointing the future trajectory of the economy is generally considered more difficult near turning points in the business cycle—though the current uncertainty would appear to be particularly large, recession or not. Such uncertainty about the future is surely adding to the challenges facing the business community as it strives to get back on its feet.

By Laurel Graefe, economic research analyst at the Federal Reserve Bank of Atlanta

CPI: The left and the right of it

Updated 11:30 a.m.

We got a good reading of May's inflation numbers this week. On both the producer and the consumer sides, price measures for the month came in well short of market expectations. The prospect of deflation has been getting a good deal of coverage in the blogosphere; see Andy Harless' blog, Economist's View, and Paul Krugman's column.

Greg Mankiw, however, points out that a trimmed mean estimate of the consumer price index (CPI), which removes the large relative price changes in each month, makes the deflation story seem a bit, uh, exaggerated.

"As every grade school student learns when the teacher reports results of the latest test, the average of any data set can be thrown off by a few extreme outliers; the median is a more robust statistic to estimate the central tendency in the data.

"Right now, the two measures of inflation are diverging substantially. The standard CPI shows deflation over the past year, but that average is due to a few anomalous sectors, such as energy. If you look at the median CPI, which shows what a more typical price is doing, the inflation rate does not look very unusual."

While the median is certainly a valuable way to look at inflation, there is also some interesting information that can be gleaned from breaking down the whole distribution of prices.

The chart below (hat tip to Brent Meyer at the Cleveland Fed) shows another interesting feature of yesterday's CPI release. Notice the clear downward shift in the distribution of CPI component price changes. Over half of the prices within the CPI market basket posted growth at or below 1 percent last month, up from an average of 29 percent in 2008, with a whopping one-third of the price index posting declines in May.

Of course, one month does not a trend make, but the month's price numbers were nonetheless noteworthy.

By Laurel Graefe, economic research analyst at the Atlanta Fed

Price stability and the monetary base

Arthur Laffer, as several readers (and friends) have pointed out to me, is taking aim at the Fed:

"… as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

"About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base—which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash—by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position."

I have a few problems with that statement. To begin with, the notion that the Federal Reserve signaled a 180-degree shift in focus to move "from an anti-inflation position to an anti-deflation position" is about equivalent to saying that the temperature control system in your house has a fundamentally different objective when the heater kicks off in June and the air conditioning kicks on. The essence of an inflation objective—even an implicit one—is that a central bank will lean against price-level changes substantially below the desired rate, as well as changes substantially above the desired rate. You can certainly argue with the policymakers' forecasts and diagnoses of risks at any given time, but it serves the debate well to not muddle tactics (focusing on inflation or deflation as the economic weather requires) and objectives (the control of the inflation rate that is Mr. Laffer's true concern).

But that point is a quibble. The increase in the U.S. monetary base has indeed been something to behold, and the Laffer article gives a good explanation about why you might be worried about that:

"Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

"Banks are required to hold a certain fraction of their liabilities—demand deposits and other checkable deposits—in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans…

"At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century."

OK, but in my opinion it is a bit of a stretch—so far, at least—to correlate monetary base growth with bank loan growth:

Let's call that more than a bit of a stretch.

The Laffer argument is in large part about what the future will bring. But we know that the payment of interest on bank reserves—which we have discussed in this forum many times (here and here, for example)—means a higher demand for reserves in the future than in the past. This change, of course, means that levels of the monetary base that would have seemed scary in the past will become the new normal. How big can the "new normal" be? That's a good question, and one I will continue to contemplate. But the assertion in the Laffer article that "a major contraction in monetary base" is required cannot be supported by either current evidence or simple economic theory.

There is, however, more. Whatever policy choices are required to deliver a noninflationary environment going forward, Mr. Laffer seems convinced that the central bank is not up to making them:

"Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds."

On this I will just turn to my boss, Atlanta Fed President Dennis Lockhart, who addressed this very issue in a speech given today at the National Association of Securities Professionals Annual Pension and Financial Services Conference in Atlanta:

"The concerns about our economic path are crystallized in doubts expressed in some quarters about the Federal Reserve's ability to fulfill its obligation to deliver low and stable inflation in the face of very large current and prospective federal deficits. In a word, the concerns are about monetization of the resulting federal debt.

"I do not dismiss these concerns out of hand. I also recognize that the task of pursuing the Fed's dual mandate of price stability and sustainable growth will be greatly complicated should deliberate and timely action to address our fiscal imbalances fail to materialize. But I have full confidence in the Federal Reserve's ability and resolve to meet its inflation objectives in whatever environment presents itself. Of the many risks the U.S. and global economies still confront, I firmly believe the Fed losing sight of its inflation objectives is not among them."

'Nuff said, for now.

By David Altig, senior vice president and research director, at the Atlanta Fed

Debt and money

If you are hunkered down on inflation watch, yesterday's news offered some soothing words. From Reuters:

"Chinese officials have expressed concern that heavy deficit spending and an ultra-loose monetary policy could spark inflation, eroding the value of China's U.S. bond holdings.

"But [U.S. Treasury Secretary Timothy] Geithner said: 'We have a strong, independent Fed and I am completely confident they have the ability to do their job under the law, which is to keep inflation stable and low over time, and that they will be able to—and certainly intend to—unwind these exceptional measures as soon as they have served their purpose.' "

And from Bloomberg:

"He said that there was 'no risk' of the U.S. monetizing its debt, a response to a question about whether the government would seek to finance the national debt by expanding the money supply and thus trigger a rise in inflation."

Concerns about such monetization arose in the wake of the FOMC's decision at its March meeting to purchase up to $300 billion of longer-term Treasury securities and that decision's coincidence with the very large fiscal deficits contemplated in President Obama's budget proposals. Those concerns have accelerated as longer-term Treasury yields have moved higher since.

There will, I trust, be plenty of opportunity to expand on these concerns as things develop, but for now I will offer just a little perspective in the form of the chart below, which shows the recent and (near-term) prospective shares of federal debt held by the Federal Reserve. The red line represents the share of debt that will be held by the Fed at the end of fiscal year 2009 if the $300 billion Treasury purchase program is completed and the federal deficit emerges as currently predicted by the Congressional Budget Office.

The financial crisis has, of course, borne witness to the shift in the Fed's balance sheet from Treasuries (which have been much in demand by the private sector) to a variety of loans and mortgage-backed securities. The consequence has been a sharp fall in the fraction of government debt held by the central bank, a fact that will be little changed under the current trajectory of Fed purchases and projected deficit spending.

A large decline in Fed holdings of Treasury bills—securities that mature in one year or less—drives much of the pattern seen in the chart above. The drop-off in share is not as large for Treasury notes—securities in the two- to ten-year maturity range, and some assumptions have to be made to get a picture of how the Fed's share might evolve over the near term. Without knowing how this evolution will occur, I developed two general assumptions for argument sake. If net new issues of Treasury debt follow historical averages, meaning just over half of net new debt is in the form of notes, and if the central bank applies the remainder of the $300 billion of longer-term Treasury purchases (about $170 billion at the end May) to notes, then the Fed would hold roughly 13 percent of the outstanding stock by the end of the year. If the Treasury were to issue nothing but bills or bonds, a $170 billion purchase of notes by the Fed would bring its share up to the neighborhood of 17 percent. Though these numbers are not as unusually low in historical context as is the case for total outstanding debt, neither would they jump off the page as an extreme aberration in the other direction.

Some might argue that "monetization" these days involves a whole lot more than government debt, but Chairman Bernanke has been pretty clear about his intentions regarding the overall size of the Fed's balance sheet. And, as I see it, so far allegations that extraordinary steps are being taken specifically to accommodate fiscal deficits are properly characterized as risk rather than fact.

By David Altig, senior vice president and research director at the Atlanta Fed

The mean and the variance of the longer-term inflation outlook

Ever hear the one about the statistician who had his head in the oven, his feet in the freezer, but who said he felt fine—on average? We kind of feel that way when we look at the recent distribution of inflation forecasts. Not only does the Federal Reserve Bank of Atlanta produce its own economic forecasts, but we’re also eager consumers of others’ forecasts. That’s because we believe there is useful information to be learned from varying views. For one thing, it helps to reveal the risks. The current inflation forecast is a good case-in-point.

Figure 1 shows the consensus CPI forecast for the Blue Chip panel of economic forecasters from March 10:

 

The “average” forecast shows CPI-measured inflation falling at a 2.25 percent (annualized) pace in the current quarter, followed by a modest .25 percent rise in the second quarter and then gradually climbing to a 2 percent growth trend in the second half of next year.

Our interpretation of the Blue Chip consensus inflation forecast (if such a thing is really possible, since it’s merely an average of many forecasts) is that falling energy and other commodity prices combined with a large amount of economic slack is likely to exert considerable downward pressure on inflation over the next few quarters. But as the economy gradually recovers, we should begin to see a gradual return of inflation to something closer to what the Federal Reserve sees as consistent with price stability.

OK, that’s the combined wisdom of the 50-some members of the consensus forecast panel. But there’s a bit more to the story than just the average forecast. Consider the 10 highest inflation forecasts relative to the 10 lowest. The inflation “optimists” see the CPI tracking at, or a shade under, 0.5 percent over the forecast horizon, while the pessimists see inflation continuing to move higher and topping 3 percent (annualized) in the second half of 2010. Now, some discrepancy in economic forecasts is to be expected, but the range of disagreement in the Blue Chip forecast about the longer-term inflation trend—at a little over 3 percentage points—is an exceptionally large spread. (By our calculations, it’s about twice the spread of the group’s longer-term average inflation prediction.)

However, we’ve got a pretty good idea of what’s causing such a large discrepancy. There likely are two competing and seemingly large risks within the consensus. First, some of these forecasters may believe the economy will not rebound in the way that is implied by the forecast average, which is to say that the economic slack (see Friday’s jobs report) putting downward pressure on inflation may be with us for some time. These forces could be exacerbated and prolonged if the public were to incorporate the lower near-term price behavior into their longer-term inflation expectations. We’re going to speculate that this is the inflation scenario the Blue Chip inflation “optimists” have in mind.

On the other side, some of these Blue Chip forecasters may believe the economy will do an abrupt about-face and climb out of the recession more adeptly than the consensus now predicts. In their view, if it does, and the Federal Reserve is not adept at shrinking the size of its balance sheet, there would be the proverbial inflationary scenario of “too much money chasing too few goods.” And, again, if the public incorporates this scenario into their expectations, the prediction of the inflationary pessimists comes to pass.

These competing inflation scenarios were a topic of conversation at the January Federal Open Market Committee (FOMC) meeting (below is a quote from the minutes of that meeting):

“Many [FOMC meeting] participants noted some risk of a protracted period of excessively low inflation, especially if inflation expectations were to move down in response to lower actual inflation and increasing economic slack, and a few even saw some risk of deflation.

“Several others, however, anticipated that longer-run inflation expectations would remain well anchored, supported in part by the Federal Reserve’s aggressive expansion of its balance sheet and the resulting growth of the monetary base…some noted a risk that expected inflation might actually increase to an undesirably high level if the public does not understand that the Federal Reserve’s liquidity facilities will be wound down and its balance sheet will shrink as economic and financial conditions improve.”

One risk has feet in the fire—the other in the freezer. Here’s hoping that the consensus is right.

Update from April 6, 2009:

The April 10 Blue Chip report came out today, showing a further widening of the spread between the forecasts for CPI inflation. While the mean forecast was revised only slightly, the difference between the top and bottom 10 forecasts for Q4 2010 increased by a full percentage point, from 3.3 to 4.3.

 

By Michael Bryan, vice president, and Laurel Graefe, economic analyst, in the research department at the Atlanta Fed

Yet another cut at the recent retail price data

Much of modern business cycle theory—and the policy prescriptions that accompany it—rest on the idea that something interferes with markets. After all, if markets are working efficiently, there isn't anything that policy can do to improve matters. What that "something" is remains the great unknown in macroeconomics, but there is a common belief that price "stickiness" lies at the heart of the problem.

While economists wrestle with the question of what, exactly, causes prices to be sticky—that is, adjust more slowly than they would in the absence of whatever is getting in their way—some have taken on the tedious task of documenting the speed at which prices adjust. And, as you might imagine, it turns out that some prices adjust very quickly while others adjust at a glacial pace.

One of the most comprehensive investigations into the evidence of price stickiness was published a few years ago by economists Mark Bils of the University of Rochester and Peter Klenow of Stanford. Bils and Klenow dug through the unpublished data that are used to construct the consumer price index (CPI) and computed the frequency of price changes for 350 detailed spending categories. They concluded that between 1995 and 1997, half of these categories changed their prices at least every 4.3 months. Some categories changed their prices much more frequently. Price changes for tomatoes occurred about every three weeks. And some, like coin-operated laundries, changed prices on average only every 6½ years or so.

It has been argued—notably by Kosuke Aoki of the London School of Economics—that sticky prices are likely to incorporate forward-looking expectations and are therefore "a good candidate for a measure of core inflation."

We decided to take the data we use to compute another measure of core inflation—the median CPI—to produce a "sticky-price" and "flexible-price" CPI. There are some complications to this seemingly simple exercise. First, it isn't clear where one should draw the line between a sticky price and a flexible price. We rather arbitrarily decided to draw two lines, one at four months and another at six months. If price changes for a particular CPI component occur on average every four months or more frequently, we called that component a "flexible" price good and, if changes occurred less often than every six months, we labeled it a "sticky" price good. (We have called goods that change prices somewhere between every four and six months "semiflexible" and are generally ignoring them in this particular exercise.)

Second, since we're dealing with considerably fewer spending categories than Bils and Klenow did, we could only imperfectly match our data set to their results, so admittedly some art was applied in instances where sticky price goods and flexible price goods coexisted in the same spending category.

Those cautions aside, here's what we came up with, looking at data between 1998 and 2009.

Figure 1 shows the weighted distribution of the CPI market basket on the basis of its degree of price stickiness. In terms of the overall, or "headline" CPI, we judge that a little more than 50 percent of the index is composed of sticky price goods, 40 percent of the index is made up of flexible price goods, and the remainder is somewhere in between.

So, what do these measures tell us? Figure 2 below shows the four-month percent change in the sticky CPI and the flexible CPI, with the headline and the traditional core CPI included as dotted lines for reference.

Clearly the sticky-price CPI exhibits relatively smooth patterns, very similar to that exhibited by the traditional core CPI, while the flexible price CPI behaves in a way more consistent with the headline CPI. Such a correspondence between the core measure and the sticky-price measure isn't very surprising since food and energy items are heavily (though not exclusively) flexible price goods (see again figure 1).

So we also produced "core" measures of the sticky and flexible CPI (the sticky and flexible price CPI measures less food and energy), and these data are shown in figure 3.

One observation from this calculation is that sticky prices have tended to rise at a pace above the core flexible prices for a considerable period of time. Obviously something more than degree of price flexibility distinguishes these two price measures. But as an exercise in reading the incoming price data, the sharp drop in the flexible component of the core CPI is another clear indication of the strong disinflationary pressure on retail prices in recent months. Over the past four months, the core flexible CPI has fallen at a 2.6 percent pace, just a shade more than what we saw during the disinflation of 2003. And the sticky price core CPI? Well, it hasn't moved much—it's sticky. But the longer the disinflationary pressures on the economy persist, the more these prices will likely become unstuck as they too begin to reflect the price adjustments being reflected elsewhere in the consumer's market basket.

By Michael Bryan, Federal Reserve Bank of Atlanta, and Brent Meyer, Federal Reserve Bank of Cleveland

On expanding balance sheets and inflationary policy

Here's a question I hear a lot (most recently during the Q&A portion of a speech delivered yesterday by my boss, Atlanta Fed president Dennis Lockhart): Has monetary policy become so expansive that the central bank's mandate to maintain price stability has been fundamentally compromised? Is the increase in the scale of the Federal Reserve's balance sheet inherently inflationary?

Jim Hamilton covered much of the territory implied by these questions in a very extensive Econbrowser post not too long ago, but the distinction between money creation and Fed balance sheet expansion continues to be confounded. Here, for example, is a passage from the Wall Street Journal's Real Time Economics coverage of Stanford professor John Taylor's (not exactly glowing) review of recent Federal Reserve action, delivered at this year's annual meeting of the American Economic Association:

"The Fed has launched nearly a dozen new programs in the past year to address the crisis. Its strategy is to target specific markets in distress—from commercial paper to asset backed securities to money market mutual funds and stresses overseas—with programs tailored to their problems. It also has gotten deeply involved in rescues of individual firms like Bear Stearns, American International Group and Citigroup.

"The Fed has funded these programs by pumping reserves into the banking system—essentially creating new money. In the process, its balance sheet has ballooned from less than $900 billion to more than $2 trillion."

The record though, as the article goes on to note, is that not all of that $2 trillion represents an increase in the money supply:

Only the blue portion of the graph above represents "pumping reserves into the banking system"—a fact that was covered pretty well in the aforementioned Econbrowser post—and in an even earlier post at News N Economics. In simple terms, the size of the Fed's balance sheet is not the same thing as the size of the monetary base (the sum of currency in circulation and reserve balances kept by banks with the Federal Reserve).

Of course, John Taylor's point was not that all of the increase in the balance sheet has amounted to pumping in reserves, just that a lot of it has, which is clearly true. But even here there may be less to the potential inflationary impact than meets the eye. In his speech at the London School of Economics earlier today, Chairman Bernanke explained:

"Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base."

Last week Greg Mankiw had a nifty graph (courtesy of Professor Bill Seyfried of Rollins College) of the so-called money multiplier precisely illustrating the point:

The money multiplier measures the amount of money in the hands of the public—the M1 measure in this case, which is composed mainly of cash and demand deposits (i.e., checking and debit accounts)—that are created by a dollar of monetary base. That amount fell considerably when the Fed introduced the payment of interest on bank reserves.

That said, despite the fall in the money multiplier, the M1 measure of money has also expanded fairly noticeably since late summer:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

The increase in M2—a slightly broader measure of money that adds to M1 items like savings accounts and time deposits—has been somewhat slower but still on the rise:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

From December 2007 through August of last year, M1 and M2 grew by about 1.2 percent and 3.9 percent respectively. Since September—after which the rapid expansion of the Fed's balance sheet began and the Fed began to pay interest on reserves—the corresponding growth rates have been 13.4 percent and 5.9 percent.

Are those growth rates substantial? That is a tricky question—whether a particular growth rate of money is substantial or not can only be determined in relation to the pace of money demand (which has almost certainly accelerated as interest rates have fallen and the taste for safe and liquid assets risen). But I take two lessons from our early experience with the asset-oriented policies emphasized in the Bernanke and Lockhart speeches. First, expansions of the balance sheet need not imply expansions of the money supply. Furthermore, as Chairman Bernanke emphasized, the Fed has the capacity to contract reserves going forward:

"… the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system."

The second lesson, clear in the M1 and M2 charts above, is that despite the payment of interest on reserves and near-zero federal funds rates, it is still possible to induce increases in the broad money supply through the standard channel of injecting reserves into the banking system.

Whatever direction you think the money supply ought to go, these observations should come as comforting news.

By David Altig, senior vice president and research director at the Atlanta Fed

Thoughts on reading the October CPI

Here is what we know about the October consumer price index (CPI). The overall index declined at an annualized rate of about 11 percent for the month—it’s sharpest fall since 1947. A plunge in gasoline prices played a big part in the decline, but that isn’t the whole story. The traditional “core” CPI, which excludes food and energy prices, also declined in October (at an annualized rate of about 1 percent). This is the first decline in the core CPI since 1982.

Let me offer an opinion on what may be behind these numbers. The drop-off in consumer prices seems to have been prompted by a number of factors, including some pass-through from sharply lower commodity prices, a stronger dollar (which makes import prices cheaper), and very soft consumer spending.

But here’s what I don’t know. Is the October CPI a sign of “deflation"? (and it would appear that many of you are interested in finding an answer to this question). Before you answer the question for me, consider the following: In order to be “deflation” the decline in prices has to be sustained and broadly based. And I’m not sure I can give you much guidance on how long the decline must be in order for it to qualify as sustained, and I sure can’t tell you how broadly-based a general decline in prices is. Consider the distribution of CPI component price changes in figure 1. About one-third of the prices in the CPI market basket declined last month, which is a fairly large percentage of the index. On the other hand, about one-third of the price index was rising in excess of 3 percent last month.

One of the things I like to consider when thinking about how “sustainable” and “general” the monthly CPI data are is to consider the behavior of the trimmed-mean estimators of the CPI. A trimmed-mean estimator is the weighted average of the CPI after some proportion of the extreme values of the index are “trimmed” away. The idea of the trimmed-mean estimator is that extreme price changes are not representative of prices in general. Moreover, there is ample evidence that the more extreme the price change, the less sustained it is likely to be.

We can trim any proportion of the data away. In fact, we can trim it all away such that only the median price change remains (this is the Cleveland Fed’s median CPI series.) Consider figure 2, which shows all the various trimmed mean estimators of the October CPI data, from a CPI that trims very little of the index to one that trims away most of the index. How much trimming provides the best perspective from which to judge how sustainable and general the monthly price data are? In the past, I’ve argued that two indicators stand out, the 16 percent trimmed-mean CPI (trimming 8 percent of the most extreme highs and 8 percent of the most extreme lows from the data) and the median CPI. I’ve highlighted these values in figure 2. While the overall CPI posted a sharp decline, the 16 percent trimmed-mean CPI posted a rather slight 0.6 percent decline, and the median CPI rose 1.8 percent.

But, admittedly, knowing which trim of the data best represents how sustainable and general a monthly price report is, is not very clear. So let me offer up a range for you to consider: the interquartile range of the trimmed-mean estimators. An interquartile range is merely the spread between the 75th and the 25th percentile of the estimators. As such, it provides a relatively stable spread of the estimators from which to gauge the range over which prices are “generally” rising (or falling.) Figure 3 shows the interquartile range of the various CPI trimmed-mean estimators monthly since 2004 compared to the traditional core CPI. The interquartile range of the October CPI data is from 0.5 percent to 1.5 percent, shown as the last vertical line in figure 3, and 1.5 percentage points above the core measure.

So when the boss asks me what I thought of the October CPI report and what does that single number tell us about inflation (or deflation), my answer is this: The overall and the core CPI posted declines for the month and clearly there is significant, rather broadly based downward pressure on retail prices. But as I cut the data, it looks to me that the October CPI data is pointing to an inflation rate somewhere in the 0.5 percent to 1.5 percent range.

By Mike Bryan, vice president in the Atlanta Fed’s research department

Does the GDP deflator lie?

Though last week’s report on U.S. gross domestic product (GDP) growth in the second quarter is second-hand news by now, I’ve taken note that Barry Ritholtz’s views on the news has, in particular, continued to rumble through the blogosphere. Barry is not happy with the GDP deflator, and samples approvingly from a Barron’s article by Aaron Abelson:

“GDP, in common parlance, stands for gross domestic product, or the aggregate value of all the goods and services produced on these blessed shores... These days, alas, those initials more typically signify “gross deceptive pap”...

“Comes now the so-called preliminary estimate that claims second-quarter GDP grew by a much more robust 3.3%.

“The key here is the GDP deflator, which purports to adjust GDP for the impact of inflation; it’s a curious calculation in that, contrary to its moniker, it seems designed to do the exact opposite of deflating GDP.

“Thus, according to this accommodating measure (accommodating, that is, if you’re determined to put a good face on a dreary report), inflation grew at an improbably restrained 1.33% in April-June. And maybe it did—but not in the good old U.S. of A. However, obviously more important than accuracy to those doing the calculating is this simple equation: The lower the deflator, the greater the growth of GDP…

“Of course, even by the government’s not entirely extravagant figuring, the consumer price index was up a hefty 8% in the latest quarter. Perhaps the computer that tallies the CPI doesn’t talk to the computer that measures the deflator.”

Strong words, but if you ask me, misguided. Barry actually makes the case against the case in this picture, about which he notes:

“It’s no coincidence that the current situation resembles past ones where oil prices had spiked. Since more than half of the U.S. Crude consumption is imported, the price and quantity go into all GDP calculations as a negative.”

Exactly. Let me provide an elaboration of the spot-on point made at The visible hand in economics blog. For the sake of argument assume that every drop of oil consumed in the United States is imported, and everything imported to the United States is oil. If we leave exports out of the picture for simplicity, we can think of U.S. consumption as consisting of GDP—everything produced in the United States—and imported oil.

Suppose, then, that the price of oil rises precipitously. If both incomes and oil consumption are relatively fixed in the short-run, what would we expect to happen? The answer is more expenditure on imported oil and less spending on everything else. As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.) Since domestically produced goods and services by definition constitute GDP, GDP-deflator inflation will be low, while the consumer price index (which would include nonexported GDP plus imports) could well be quite high.

Voila! A simple Econ-101 explanation, with nary an insult hurled at the good folks from the Bureau of Economic Analysis.

That said, there are plenty of reasons to be cautious in interpreting last week’s report. Mark Thoma has a fine roundup of many fine points by many fine bloggers. To that list I’d add comments by Spencer at Angry Bear, William Polley, Lim at The Skeptical Speculator, Ben Leeson at Working Thoughts, Zubin Jelveh and Felix Salmon (both at Portfolio.com), to name a few. But I would delete the suspicion that low GDP-deflator-based inflation suggests shenanigans are afoot.

Monitoring the inflation bees, striving not to get stung

As pure blogging fodder, Willem Buiter’s Jackson Hole “advice” to the Fed is a gift that keeps on giving. From Buiter’s paper:

“It has not always been clear whether the Fed actually targets core inflation or whether it targets headline inflation in the medium term and treats core inflation as the best predictor of medium-term inflation.”

As luck would have it, our boss (Federal Reserve Bank of Atlanta President Dennis Lockhart) had a few words to say on exactly that topic yesterday:

“Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty—especially when making decisions in real time. Discerning accurately the underlying trend is difficult.”

The difficulty of precisely “separating the inflation signal from the noise” is not a new problem. In fact, this difficulty can be traced at least as far back as the development of index numbers to measure economic aggregates—and aggregate inflation in particular—by the famous economist Irving Fisher. Fisher struggled with the idea of being able to separate out the general movement in prices from the relative price disturbances:

“It would be idle to expect a uniform movement in prices as to expect a uniform movement for bees in a swarm. On the other hand, it would be as idle to deny the existence of a general movement of prices ... as to deny a general movement of a swarm of bees because the individual bees have different movements.”

The distinction between the direction of the swarm and the individual bees is an important one that is the direct path to discussions of measures of “core” inflation. The conceptual issues were nicely articulated in a recent article by Dallas Fed economist Mark Wynne, and they go something like this: Suppose we thought of the percent changes in prices of individual goods and services between two periods as containing a common component (core) and price changes that are unique to the supply and demand conditions of a particular products markets. The object of our desire (the honey if you like) is the level and direction of the common component. The problem is how to measure it.

In his commentary on the “will-o’-the-wisp of ‘core’ inflation,” Professor Buiter decides on a selective concept of core:

“The only measure of core inflation I shall discuss is the one used by the Fed, that is the inflation rate of the standard headline CPI or PCE deflator excluding food and energy prices. Other approaches to measuring core inflation… will not be considered.”

We added the emphasis because we want to contrast that comment with these words from President Lockhart’s speech:

“It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.”

The variety of core measures is in fact wide. Some are familiar—the traditional statistics that exclude food and energy prices, the Cleveland Fed median CPI, and the Dallas Fed trimmed-mean PCE are examples. Some important, but less familiar, measures focus on persistence over time in individual price changes and exploit correlation over time in the common and product-specific components. Work by Michael Bryan and Steven Cecchetti and Domenico Giannone and Tyler Matheson  are examples.  An alternative approach is to define core inflation by decomposing headline inflation measures into permanent and transitory components, identifying core inflation as the permanent component. Examples include research by Jim Nason and James Stock and Mark Watson.

Michael Kiley just recently extended the Stock and Watson approach and found the common trend in inflation during the 1970s and early 1980s was attributable to persistent movements in both energy/food and nonenergy/food prices. More recently, that trend has been less influenced by food and energy inflation.

Maybe that isn’t all good news. It is noteworthy that the traditional measures of underlying trend inflation have moved higher over the past year or so, some more than others.

As President Lockhart noted at several points in his remarks yesterday:

“No matter how you measure it, the aggregate inflation we are experiencing in the United States at the moment is uncomfortably high…

“Measures of core inflation in the United States suggest that overall price pressures have been on the rise, perhaps because higher commodities costs have begun to affect prices paid by consumers and businesses across a broader range of other goods and services…

“I'm acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve's institutional commitment to maintaining low and stable inflation will prevail.”

Professor Buiter raised several theoretical challenges to the core inflation concept that deserve discussion. It really is time, however, to lay to rest the straw-man assertion that central bankers are diverted by a pursuit of single and overly simplistic notions of core inflation.

By John Robertson, vice president in the Atlanta Fed’s research department, and David Altig, senior vice president and research director at the Atlanta Fed