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Tuesday, July 29, 2003

An Unwelcome Fall in Inflation

Some extracts from, and a link to, the recent Ben Bernanke speech which has caused all the fuss. The implicit output gap argument seems sound enough to me, I also think he's right to trace the current disinflationary pressures backwards and look again at the productivity/inflation situation during the 'new economy' boom. What this effectively means is that the process of capacity expansion outstripping aggregate demand effectively started earlier. Now why was this? The conventional argument is the internet-driven bubble. But this only takes things back one more step: why was there so much liquidity swimming around?

What I don't see - in what I am now coming to call the 'Treasury view' (whether in its monetary or structural variants) - is any analysis or explanation of why we might be having this continuing weakness in aggregate demand. This, as I see it is the soft spot, or weak point in the argument.

Following Lindh and Malmberg I do have a rough back-of-the-envelope model that can handle this, based around demography, cohorts, and either (take your pick) the life cycle, or the permanent income hypothesis. Is there something I am missing?

This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so. Both the apparent tendency of measured inflation to overstate the true rate of price increase, as suggested by a range of studies, and the need to provide some buffer against accidental deflation serve as rationales for aiming for positive (as opposed to zero) measured inflation, both in the short run and in the long run. To the extent that one accepts the view that measured inflation should be kept some distance above zero, a very low positive measured rate of inflation (say, 1/2 percent to 1 percent per year) is undesirable and implies a need for highly accommodative monetary policy, just as would be required for outright deflation. The language of the May 6 statement encompasses the risks of both very low inflation and deflation. I suspect that for the foreseeable future, of the two, the risk of very low but positive inflation is considerably the greater. That is, inflation in the range of 1/2 percent per year in the United States in the next couple of years, though relatively unlikely, is considerably more likely than deflation of 1/2 percent per year............

A second set of circumstances in which deflation or very low inflation may pose significant problems is potentially more relevant to the current U.S. economy. That situation is one in which aggregate demand is insufficient to sustain strong growth, even when the short-term real interest rate is zero or negative. Deflation (or very low inflation) poses a potential problem when aggregate demand is insufficient because deflation places a lower limit on the real short-term interest rate that can be engineered by monetary policymakers. This limit is a consequence of the well-known zero-lower-bound constraint on nominal interest rates. For example, if prices are falling at a rate of 1 percent per year, the short-term real interest rate cannot be reduced below 1 percent, since doing so would require setting the nominal interest rate below zero, which is impossible. (Likewise, the very low inflation rate of 1/2 percent would prevent setting the real interest rate lower than minus 1/2 percent.) Thus, in a situation of insufficient aggregate demand, deflation or very low inflation might prevent the Fed from achieving full employment, at least by means of the Fed's traditional policy tool of changing the short-term nominal interest rate.........

the factor most likely to exert downward pressure on the future course of inflation in the United States is the degree of economic slack that is currently prevailing and will likely continue for some time yet. Although (according to the National Bureau of Economic Research) the U.S. economy is technically in a recovery, job losses have remained significant this year, and capacity utilization in the industrial sector (the only sector for which estimates are available) is still low, suggesting that resource utilization for the economy as a whole is well below normal. By conventional analyses, therefore, even if the pace of real activity picks up considerably this year and next, persistent slack might result in continuing disinflation.5

A highly simplified, though not quantitatively unreasonable, calculation may help. Let us suppose that economic activity does pick up in the second half of this year, by enough to bring real GDP growth in line with its long-run potential growth rate--roughly 3 percent or so, by conventional estimates. Moreover, suppose that activity strengthens further next year so, so that real GDP growth climbs to approximately 4 percent, a full percentage point above potential. What will happen to resource utilization and inflation?

Focusing first on the implications for economic slack, we note that this projected path for real GDP gap would imply no change in the output gap through the end of this year, followed by a percentage point reduction in the output gap during 2004. Given the average historical relationship between the change in the output gap and labor market conditions, known as Okun's Law, the unemployment rate would be expected to remain at about its current level of 6.4 percent through the end of the year and then decline gradually to about 6.0 percent by the end of next year. This projection is fairly close to many private-sector forecasts.

Let us turn now to the implications for inflation. From 1994 to 2002, core PCE inflation remained in a stable range while the unemployment rate averaged about 5 percent; so let us suppose, for purposes of this example, that the unemployment rate at which inflation is stable is 5 percent. (If the unemployment rate at which inflation is stable is lower than 5 percent, the disinflation problem I am discussing becomes larger.) A little arithmetic shows that this scenario involves 1.9 point-years of extra unemployment (relative to the full-employment benchmark) between now and the end of 2004. Now make the additional assumption that the sacrifice ratio (the point-years of unemployment required to reduce inflation by 1 point) is 4.0, a high value by historical standards but one in the range of many current estimates. Then the additional disinflation between now and the end of next year should be about 1.9 divided by 4, or about 0.5 percentage points. So given our assumptions about GDP growth, core PCE inflation, say, might fall from 1.2 percent currently to 0.7 percent or so by the end of 2004.

The precise figures I have used in this exercise should be taken with more than a few grains of salt. But the bottom line (which would not be much affected if we played around with the numbers) is that, even if the economy recovers smartly for the rest of this year and next, the ongoing slack in the economy may still lead to continuing disinflation. So the FOMC's May 6 statement, by indicating both balanced risks to economic growth (that is, a reasonable chance of a good recovery) and a downward risk to inflation, had no internal inconsistency.

Now, further disinflation of half a percentage point in conjunction with a significant strengthening of the real economy would not pose a significant problem. But of course, the simple scenario I just outlined has risks. If the recovery is significantly weaker than we hope, for example, the greater level and persistence of economic slack could intensify disinflationary pressures at an inopportune time. Another possibility, given the uncertainty inherent in measures of potential output, is that the amount of effective slack currently in the economy is greater than most analysts think--which, if true, would help to explain the recent pace of disinflation.

There are good reasons not to discount this possibility. For example, during the late 1990s, economists worked hard to explain the combination of an unusually low unemployment rate and stable inflation--possible evidence of a decline in the economy's sustainable unemployment rate. Factors that were thought to have contributed to a lower sustainable rate of unemployment included the maturation of the labor force (Shimer, 1998); increased numbers of people on disability insurance (Autor and Duggan, 2002) and increased rates of incarceration (Katz and Krueger, 1999), both of which tended to remove less employable individuals from the labor force; improved matching between workers and jobs, facilitated by increased access to the Internet and the rise of temporary help agencies (Katz and Krueger, 1999); and perhaps other factors as well. Many of these forces continue to operate in today's economy, conceivably with greater force than in the late 1990s.6 In addition, measured labor productivity has continued to increase rapidly since early 2001--remarkably so, considering that productivity tends to be strongly procyclical--raising the possibility that we have underestimated the degree to which innovation and better use of existing resources have increased potential output. If so, the true level of slack in the economy is higher than conventional estimates suggest, implying that incipient disinflationary pressures may be more intense............

One more element of the model for inflation is important to mention: the error term. At the upcoming August meeting, the Board staff, as it always does, will present the FOMC with its forecasts for inflation. Based on historical experience (using actual staff forecasts for 1985-97), the staff's forecast for CPI inflation for the full year 2003 (that is, the current year) will prove fairly accurate; the confidence interval for that forecast, as measured by the root mean squared error, will be only 0.3 percentage points. However, if history is a guide, the forecast the staff provides next month for CPI inflation during 2004 will have a confidence interval of about 1.0 percentage points, a fairly wide range. This amount of uncertainty is no reason to be defeatist about trying to forecast inflation but it is a reason to be cautious. We are currently in a range where undershooting our inflation objective by 1 percentage point is more costly than overshooting by 1 percentage point. All else being equal, that fact should put us on our guard against unwanted further declines in inflation.
Source: Ben Bernanke Speech to the UCSD Economics Round Table

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