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Slack, inflation, and the Fed

Summary:
What with Chair Yellen testifying in Congress over the last couple of days, I’ve been trying to dig into the case for forthcoming Fed rate hikes. Clearly, there is more price pressure in the system than in recent months, but there are also these factors to consider: –The data-driven case for rate hikes is far from a slam dunk, according to evidence I present in the WaPo today.* –Today’s inflation report is interesting in that it gives ammo to both hawks and doves. Here’s the figure from BLS: Source: BLS What’s happening here is that energy costs are normalizing, after being freakishly low for awhile (see figure below). From the perspective of Fed and monetary policy, the key insight here is that energy costs are set on global markets and thus not a reflection of US capacity constraints. That’s why they’ve largely focused on the core, which reveals little acceleration in the above figure. (Dean Baker also pointed out a spike in prices of new cars last month–that’s a monthly anomaly.) I should also note that the CPI core runs about 0.5 ppts above the PCE core, so think of the Fed’s target for CPI core as ~2.5 percent (as the PCE is their preferred inflation gauge).

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What with Chair Yellen testifying in Congress over the last couple of days, I’ve been trying to dig into the case for forthcoming Fed rate hikes. Clearly, there is more price pressure in the system than in recent months, but there are also these factors to consider:

–The data-driven case for rate hikes is far from a slam dunk, according to evidence I present in the WaPo today.*

–Today’s inflation report is interesting in that it gives ammo to both hawks and doves. Here’s the figure from BLS:

Slack, inflation, and the Fed

Source: BLS

What’s happening here is that energy costs are normalizing, after being freakishly low for awhile (see figure below). From the perspective of Fed and monetary policy, the key insight here is that energy costs are set on global markets and thus not a reflection of US capacity constraints. That’s why they’ve largely focused on the core, which reveals little acceleration in the above figure. (Dean Baker also pointed out a spike in prices of new cars last month–that’s a monthly anomaly.)

I should also note that the CPI core runs about 0.5 ppts above the PCE core, so think of the Fed’s target for CPI core as ~2.5 percent (as the PCE is their preferred inflation gauge).

Yr/yr energy costs

Slack, inflation, and the Fed

Source: BLS

So while I understand the case for tightening, and have tried not to get too wound up about small rate hikes, neither do I see a compelling, data-driven case for rate hikes, and that judgement includes this morning’s CPI report.

*For econometric types, there are different ways of running “rolling regressions” of the type I used in the figure in the WaPo piece. Considering that we have T observations (calendar-year quarters in this case), the approach I used estimates the equation using the sample T-n, where n is about half the sample, and then adds back one quarter at time until n is used up. The figure, which plots the coefficient on the slack variable, thus shows how that variable evolves as I add quarterly observations.

But you can also do a “fixed window” approach where you take, say, 20 year samples, for example, and then move the full window up one observation at a time (so, in this case, each regression will have 80 observations). That gives you the picture below (using the same data on core PCE as in the WaPo piece) which tells a similar story re the decreasing sensitivity of inflation to slack.

Slack, inflation, and the Fed

Source: my analysis (see data note in WaPo piece)

Jared Bernstein
Jared Bernstein joined the Center on Budget and Policy Priorities in May 2011 as a Senior Fellow. From 2009 to 2011, Bernstein was the Chief Economist and Economic Adviser to Vice President Joe Biden, Executive Director of the White House Task Force on the Middle Class, and a member of President Obama’s economic team. Prior to joining the Obama administration, Bernstein was a senior economist and the director of the Living Standards Program at the Economic Policy Institute, and between 1995 and 1996, he held the post of Deputy Chief Economist at the U.S. Department of Labor.

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