Fed minutes released on October 7 disclosed that as recently as Sept 16, Fed officials thought risks to growth and inflation were roughly equally balanced. And Federal Reserve Chairman Ben Bernanke acknowledged on the same day that though the inflation outlook had improved somewhat, it remained uncertain. The market may have taken these views as representative of central banks around the world, particularly given the ECB decision of October 2 not to reduce rates.
Following these releases, the Dow Jones index fell by about 6.5% as the market thought the internationally co-ordinated interest rate cut it had been expecting had become less likely. This and the knock-on effects on world markets then helped to force central banks to make the cut the market had expected, but on October 8.
Understandable central bank caution: Inflation is hard to forecast
Central banks’ caution about inflation risks is understandable given the experiences of 2008. Forecasting inflation is notoriously difficult. There have been big structural shifts in the world economy, such as trade and financial globalisation, and in individual economies, such as the decline in trade union power. Monetary policy itself has shifted to a far greater focus on inflation. Energy and food price shocks can be large and very hard to predict. Indeed, the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This tracks inflation quite well except at turning points because the models miss key underlying influences.
Right now inflation forecasting models are likely to go very wrong
We are now on the cusp of the most significant tuning point for inflation in the last 20 years so that the many of the standard models are likely to go badly wrong.
The economics of this are straightforward. Global output is probably falling faster than at any rate since the war, except perhaps for 1974-5. Under these circumstances, large excess capacity develops and commodity prices fall. Some still believe that emerging markets will provide a stabilising influence on the world economy, but in fact the opposite is true. Countries such as China are highly geared to exports and above all investment, which there exceeds consumer spending. Apart from infrastructure and investment in health care and education, investment is geared to growth, so if growth falls from 11% to 5%, the reduction in investment is likely to be dramatic and more than the percentage reduction in US consumer spending.
As over-capacity develops, investment in goods production may fall even further, with serious implications for GDP. It seems unlikely that governments in emerging markets can compensate swiftly enough to boost domestic consumption. Hence the demand for commodities which have been driven by emerging market growth will fall sharply. Eventually however, lower commodity prices and lower inflation act like a huge tax cut for households and will allow interest rates to fall further, and therefore stabilise economic activity.
A new, better forecasting model
In research financed by the ESRC, we have designed new forecasting models for US inflation, improving further on methods that successfully forecast the 2001 US recession and subsequent recovery.1 Our inflation models for the US consumer price index (as measured by the personal consumption expenditure deflator) build in a wide range of factors including oil prices, producer prices, unit labour costs, import prices, prices in other countries and the exchange rate, house prices, trade union density, and the unemployment rate.
The models have been tested out-of-sample on monthly data from 2000 to the present and surpass standard models by wide margins. A key element of the models is the long-run adjustment in consumer prices to costs and other prices. Unit labour costs in the US are central to the model and have remained low despite higher goods price inflation. House prices have a powerful effect in the model but enter with a long lag. Part of the reason for their importance lies in the role of rents in the consumer price index, but they may also reflect other macroeconomic influences. House price falls have offset some of the recent inflation from higher oil and food prices and will now be a major deflationary force.
Since oil and food prices are falling sharply and have further to fall, while unemployment shoots up, US consumer price inflation must fall at record rates over the next 6-12 months. It is entirely credible that the US inflation rate measured over 12 months will become negative within the next 18 months.
Can monetary policy stem deflation?
Then the debate about whether monetary policy can stem deflation and whether the zero lower bound on interest rates is a constraint will really begin. These were the issues mistakenly raised in 2001-3 when the strong US response of credit, the housing market, and consumer spending to lower interest rates should have made the debate redundant. Influenced by a misreading of Japanese experience, this led to excessive protection against the “tail risk” of deflation and helped to fuel the credit and housing bubble whose collapse triggered the current recession.
Yes, it can
Paradoxically, the faster oil prices now fall and boost household budgets, the shorter will be the period of deflation that follows. The lessons from the Japanese experience of the “lost decade” about the need to refinance the banking system have been learnt. This and important differences between the structure of the Japanese and the US economies (see Muellbauer, 2007) make a “lost decade” for the US most unlikely.
Janine Aron and John Muellbauer “New methods for forecasting inflation and its sub-components: application to the USA”, Oxford Department of Economics Discussion Paper 406, October 2008.
John Muellbauer “Housing, credit and consumer expenditure.” in Housing Finance, and Monetary Policy: a Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30-September 1, 2007, Federal Reserve Bank of Kansas City, 2007, p. 267-334.