No inflation surprises!

Since the global financial crisis, inflation hasn’t behaved as many economists and market prognosticators predicted. For example, core inflation, which removes the volatile food and energy component and is the preferred measure of price changes by economists, has been consistently low. This lack of inflation has persisted despite massive injections of stimulus money into the financial system from the Federal Reserve (Fed) in the form of quantitative easing.

With all that money slushing around in the system, many economists feared that inflation would skyrocket. However, with the exception of four months in 2011 and 2012, core personal consumption expenditures (PCE) inflation has been below the Fed’s 2% target since 2008. And even though inflation was low, it wasn’t as low as other models suggested. Models of inflation based on economic slack, such as the Phillips curve, actually predicted a much lower rate of inflation. Economists questioned why the biggest collapse in economic activity and surge in unemployment since the Great Depression didn’t lead to deflation. This conundrum is referred to as the “missing disinflation” or “missing deflation.”

A recent paper presented at the U.S. Monetary Policy Forum entitled, “Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics,” attempted to figure out why inflation hasn’t evolved as expected.[1] The authors’ time horizon is rather narrow, homing in on the post-Paul Volcker monetary policy era from 1984 to the present. During this period, particularly the last 20 years, inflation has been very stable. The researchers note that core PCE inflation stayed between 1.2% and 2.3% during that time, compared to inflation that moved between 3% and 15% in the 1970s!

Failing to meet expectations

While their methods are technical, their conclusion is elegantly simple, just as their paper title implies. What best predicts future inflation? Wait for it….the recent past of inflation. To be sure, previous well-used forecasting models of inflation are typically based on previous history in inflation. But, the key is that once taking into account past trends in inflation, the other traditional stuff that economists, including the Federal Open Market Committee, typically think do a good job of predicting inflation doesn’t matter. Economic slack didn’t matter, nor did inflation expectations. In fact, the authors show that, while the level of inflation is highly correlated with levels of inflation expectations, there is little relationship between changes in inflation and changes in inflation expectations. This is a big deal.

Like economic slack, inflation expectations, or households and market participants’ views on future inflation, are a classic predictor of inflation. The logic is that when people and businesses think prices will be higher in the future, they will start to demand higher wages and prices today. The authors found some non-traditional factors that did a good job explaining inflation trends: the dollar, financial conditions, broad money supply, and debt. Labor market slack is statistically meaningful in explaining trends in inflation but the magnitude of the effect is very small.

To sum it all up, inflation’s remarkable stability in recent decades has actually made it really hard to forecast using traditional methods. This stability in inflation is a testament to prudent, independent monetary policy in the United States and elsewhere around the globe. Inflation expectations probably don’t do a good job at predicting inflation today because central banks have done such a good job of keeping those expectations well-anchored. If central bankers let inflation overshoot too much, say by succumbing to political pressure to keep monetary policy easy for too long, then inflation may move from being surprisingly dull to unhinged. Yikes!

 

[1] Cecchettti, Stephen G., Feroli, Michael G., Hooper, Peter, Kashyap, Anil K,. and Schoenholt, Kermit L., “Deflating Inflation Expectations: The Implications of Inflation’s Simple Dynamics,” Working paper presented at U.S. Monetary Policy Forum, March 2017. https://research.chicagobooth.edu/~/media/806FC2DED9644B5DA99518D2B07CC637.pdf

 

Follow Principal Global Investors on LinkedIn

 

_________________________________________________________

Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of March 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and shouldn’t be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account

Principal Financial Group, Inc., its affiliates, and its officers, directors, employees, and agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document.

Third-party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments. Principal Global Investors does not endorse, authorize, or sponsor any third-party content. Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

©2016 Principal Financial Services, Inc.

Principal, Principal and the symbol design, and Principal Financial Group are trademarks and service marks of Principal Financial Services, Inc., a member of the Principal Financial Group. Principal Global Investors is the asset management arm of the Principal Financial Group.

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

t17031706vi