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Is Inflation decaying?

Quote from the most recent Federal Statement.

“In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments”

Inflation pressures are key. We have to know how strong the inflation “inertia” is.

Eurozone & Britain

Inflation is already decaying in the Eurozone at a recent rate of 0.7%. And across the Channel, the Bank of England is waiting for wage inflation. But they may be waiting a long time.

“They say that since there is no sign yet of a pickup in productivity growth from the very low levels that have persisted since the 2008 financial crisis, there is little room for wages to rise” (source)

Low inflation pressures in the US

“The Labor Department’s consumer-price index was up 1.5% in March from a year earlier. The producer-price index, a measure of prices that businesses receive for their goods and services, was up 1.4% from a year earlier. Prices for imported goods were down 0.6% in March from a year earlier. The employment-cost index, released Wednesday, showed U.S. employers’ compensation costs rose just 0.3% in the first quarter and 1.8% in the last year.” (source)

US compensation costs rose just 0.3% in the first quarter. Wow! Also, we see low inflation pressures from prices on imported goods. We have a stronger dollar. We can use less dollars to buy imports. That is good for consumers, but it creates problems for wage increases in businesses that have to compete with lower priced imports.

Fisher Effect and Inflation Decay

There has been a debate lately on whether inflation is low due to low nominal rates from the Central Banks, according to the Fisher Effect. As I wrote in a previous post, the key to understanding the Fisher Effect is to know the inflationary pressures, which determine the inflation “inertia” of a autoregressive coefficient on inflation. When inflation pressures are low, the inflation inertia is low, and the Fisher Effect becomes stable. Thus, continued low nominal rates in an atmosphere of low inflation pressures allows inflation to decay over time.

Here is a graph of how inflation initially reacts to lower nominal rates and then when the nominal rates go passive, like they do at the zero lower bound, inflation goes into a decay process. (ADL model used with US data added from 4Q2010 to 1Q2014)

fisher 2

I see inflation in the US wanting to fall to between 0.5% and 1.3% ( see update below) 1.1% to 1.5% according to the Fisher Effect and the muted inflation inertia we now see.

Update: When I crunch the data into a simple one-lagged period of the model, the autoregressive coefficient comes to 0.73. Quite low and reflects low inflation inertia. However with that number, the pattern in the data suggests that inflation would stay above 1.0%.

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