The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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February 19, 2005

Yet More On The Inflation-Risk Premium

In an earlier post , I suggested

...the post 1970s period does seem to be comprised of of two distinct regimes -- the 80s and the 90s.  The former was a big improvement over the 1970s, to be sure.  But it seems that another step forward in monetary policy occurred in the 1990s as well.

I had in mind both the mean of inflation and the volatility.  But reader Alzahr made an interesting observation. Here's the comment in its entirety:

The BLS changed the cpi methodology in 1983 which surely plays a part in inflation risk premium perceptions. Unfortunately, this can't really be judged from the time span in your chart.

Pre-1983 cpi calculations were based on an asset-pricing approach. Post 1983 they went flow-of-services. This meant cpi has not captured house price inflation for 20+ years.

There's also the hedonic adjustment the BLS make, begun in 1998, which flatters cpi. I think this now extends to over 30% of the cpi components (might be wrong on that guesstimate).

Toss these two back in and cpi looks less lovely.

Alzahr has a point.  The series I showed in the earlier post -- and that we almost always look at -- is contaminated by methodological changes in the index.  Fortunately, the Bureau of Labor Statistics does construct a special research series that is methodologically consistent.  The series is explained here, but in essence the BLS constructs the series -- which it calls the CPI research series -- by recalculating past values of the index using today's procedures.

Here's how the methodologically-consistent series matches up with the one we usually see.

The research series is constructed for the period prior to 1978, but it does speak to my basic contention that, for some reason, the moments of the inflation process seem to have changed again in the 1990s.  The following picture plots a time series of the five-year moving average of the standard deviation for the rates of growth calculated both the published CPI and the rate of methodologically-consistent CPI.

Again, the impression is that volatility declined in the 1980s, and then again in the 1990s.  But interestingly, this "short window" standard deviation appears to have drifted back toward 1980s levels in the past ten years or so, as noted by pgl in a comment on the earlier post.

This is all, of course, very informal -- I'm in the process of assimilating more formal analyses of inflation risk premia and the inflation process, so there will be more to come.  But this rough look at the data does raise some interesting questions.  Did we just get lucky in the 1990s?  And, if so, has the world (the financial world, in particular) caught on?

UPDATE: You can find Alzahr's blog here.

SECOND UPDATE: Waterdog and Calculated Risk have an interesting exchange below, emphasizing the "core" measure of inflation that excludes food and energy components.  Here's what the pictures look like:


This latter picture is not so kind to my conjecture that the 1990s represented a distinct regime break in monetary policy.  Chris Sims and Tao Zha have been promoting models in which we  shift back and forth between a multiple regimes. Here is one of their examples (math alert!).  Maybe that's the way to go.

February 19, 2005 in This, That, and the Other | Permalink


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» Greenspan's Interest Rate Conundrum from CalculatedRisk
...changes in the perceptions of the Fed's credibility on fighting inflation will change the risk premium. For a discussion on the declining risk premium (possibly due to improving Fed credibility), see Dr. Altig's Macroblog. [Read More]

Tracked on Feb 20, 2005 8:00:01 PM


Perhaps I am missing the point of this line of discussion. (Probably.) True enough, the CPI moved to a flow-of-services versus the old asset-price approach in the early 1980s and rightly so. This is a cost of living index, afterall, and rising home values (or any asset for that matter) do not alter one's current costs (except through the opportunity cost, such as the implied rents of one's home.) But the "problem" relevant for this discussion is that the asset-price approach applied current mortgage interest rates to home prices in their computation of housing "costs" and, in so doing, created a series that allowed inflation risk premia and other factors influencing the high and volatile interest rate environment to be reflected in the inflation statistic. So alzahr has a point that Dave has appropriately addressed with the CPI research series -- but it isn't that the CPI hasn't captured housing price inflation for 20+ years as he suggests.

Regarding comments by pgl and Dave about the slightly higher variance of the CPI since 2000 and what that might imply for the inflation risk premia-- please note that the higher "inflation variance" over the past five years is entirely centered in energy and reflects the gyrations of OPEC and not the Fed. Indeed, the monthly volatility of the so-called "core" CPI, which excludes food and energy is virtually identical between the 1995-1999 and 2000-2004 period. Isn't it remarkable that the Fed has been able to keep such an even course for the inflation statistic despite repeated and rather severe shocks to oil prices? And wouldn't that track record help to quiet the inflation fears of the marketplace?

Posted by: Waterdog | February 20, 2005 at 02:55 PM

I see Waterdog beat me to this ... but I plotted the other BLS research series (CPI less food and energy). A 5 year moving average of standard deviation of the rates of growth shows the major moves in the CPI are energy related. It also shows volatility is still declining (so the recent move up in volatility of the CPI is probably energy related).

To clarify: Is it your hypothesis that the interest rate risk premium has moved lower due to the increased credibility of the Fed with regards to fighting inflation?

Best Regards!

Posted by: CalculatedRisk | February 20, 2005 at 03:15 PM


Yes, I believe Fed credibility regarding inflation has strengthen and, with it, the inflation risk premium has fallen. Why not? They successfully beat back the "deflation" fear, they've kept "core" inflation on a relatively steady course despite sharp spikes in oil prices, and in the past several years the FOMC has (for the first time) expressed to the world the limits to which they are willing to let the inflation trend wander. Now they're even publicly debating an explicit inflation target for a post-Greenspan Fed! And even if the Fed wasn't so well behaved, wouldn't competition in the major world currency markets from central banks that now, without exception, target inflation in the 0 to 3 percent range pretty much force the Fed to follow suit? I can't see anything on which to base a rising inflation risk and I don't think the markets do either.

Posted by: Waterdog | February 20, 2005 at 05:25 PM

Waterdog, I agree. I was just asking Dr. Altig if that was his view. It appears that the risk premium is declining (if we use the core CPI) and a reasonable explanation is increasing Fed credibility. I've read several papers that argue there is a long lag between Fed policy and generally perceived policy credibility - and perhaps we are seeing the benefit of years of inflation fighting in a reduced risk premium.

Best Regards.

Posted by: CalculatedRisk | February 20, 2005 at 08:12 PM

Yes -- it is my opinion that increased credibility by the Fed has reduced the inflation-risk premium. But there is still a lot of controversy about whether we have been lucky or good -- and we only have a small sample on which to determine the truth. Furthermore, even if good policy is reponsible, history is full of lessons unlearned. So I do worry that we run the risk of declaring vicory and going home too early.

Posted by: Dave Altig | February 21, 2005 at 07:09 AM

Personally, I'd wait until 2006 before going home victoriously. It could be the case, to use a much abused word, that there has been a credibility bubble with A. Greenspan. As we all know, these are easily detected with hindsight, but it is rather harder in advance.

There are a lot of people out there who do suspect that the current debate regarding social security reform and projections of future deficits of that part of the US government has the immense political and financial benefit of focusing investor's minds away from the current and immediate massive shift to deficits in Federal government finance. Some might even term A.Greenspan's support for the latter in recent years the ultimate exercise in political cynicism.

Fortunately for the US for the time being, China, Japan and the US need each other to work together in what I have long called the global convoy system.

Still, 2006 could well turn out a most interesting year.

Posted by: godement | February 21, 2005 at 08:40 AM

thanks for the chuckle with my mornings coffee.
didn't japanese call their economic system a convoy system too?

Posted by: dilbert dogbert | February 21, 2005 at 10:41 AM


that was indeed how the idea came to me back in february 2002 when I thought that both economies were going to:
a) recover jointly as opposed to, say, Europe
b) support each others pressing need - financing a mind-gobbling expansion of the current account deficit in the US, getting support and respite to deal seriously with non performing loans in Japan.

Hey, so far, it's worked pretty well for both US and Japan.

Now, Japan has had a few bad quarters lately, which have been reported in this blog, but I'm prepared to bet that these are the pangs of a transition from export-led to investment-led recovery. Let us check the vintage of japanese productive capital, the share of investment in gdp in a historical context and the gyrations of ROA. Let us even look at land prices and residential investment. It looks unambiguous to me in terms of where investment is about to go. Hindsight of course will be the sole judge !

Posted by: godement | February 21, 2005 at 12:08 PM

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