How the Fed could improve its inflation outlook

Dee Gill | Apr 21, 2017

Sections Economics

While the US economy is in far better shape than it was a decade ago, interest rates remain unusually low—below the 2 percent target set by the Federal Reserve. The Fed has been slow to normalize interest rates, which makes its outlook for inflation of great interest. 

Two economic indicators that the Fed describes as central to its outlook are not very predictive of actual future inflation, according to a study conducted by Brandeis’s Stephen G. Cecchetti, Michael Feroli of J. P. Morgan Chase, Peter Hooper of Deutsche Bank, Chicago Booth’s Anil K Kashyap, and Kermit Schoenholtz of New York University. They hold that the strongest predictor of what inflation will do in the future is not any component of the popular model, but, rather, what it has done in the recent past.

The study demonstrates the limited relationship between future inflation and the two key components of current models used to calculate it: labor-market slack, which is the amount of people and resources not being productively employed, and inflation expectations, which are derived from surveys. When people are out of work, wages stagnate, as do prices. Conversely, when people expect inflation, they’ll demand raises and firms will pass this cost along in the form of higher prices. 

The Fed’s reliance on labor-market stats and inflation expectations helps explain why many mainstream forecasts have chronically overestimated future inflation in recent years.

But while many rely heavily on these two components to guide forecasts, the researchers argue that it makes more sense to look instead at the recent inflation trend. Once that is considered, unemployment and inflation expectations provide little additional information about future inflation, the research finds.

Of the components, inflation expectations are particularly followed, and higher inflation does typically follow forecasts of higher inflation. But that seems to be because the expectations are a proxy for the trend. If you compare how inflation and inflation predictions change, so that the trend is accounted for, inflation expectations are not all that informative, the researchers find. 

They say Fed policy makers could achieve more-accurate forecasts, and more-effective monetary policy, by expanding their forecasting model to include several underappreciated indicators, including the exchange rate, the growth of money supply, and total nonfinancial credit growth. The Fed’s heavy reliance on labor-market stats and inflation expectations helps explain why many mainstream forecasts have chronically overestimated future inflation in recent years, the researchers suggest—and this broader range of indicators could help the Fed get a better sense for when inflation really is looming.

The research could also have implications for the timing of the Fed’s future interest-rate hikes, as well as its overall strategy for achieving its inflation targets. Should the Fed allow inflation to overshoot its current 2 percent inflation target, or pursue the traditional policy of raising rates once a target is hit—this is the hot issue in monetary-policy circles. The researchers argue in favor of a modest and short-lived overshoot of the Fed’s target, concluding that this stands a better chance of creating sustained inflation at the desired level.

The researchers analyzed data between 1984 and 2016, an era of relatively low and stable inflation rates. They note that the focus on historic inflation continued to produce accurate forecasts even through the 2007–10 financial crisis.