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Is It Really Time for the Fed to Worry About Inflation

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Written by David Rosnick   
Friday, 07 March 2014 15:18

Ylan Mui at The Washington Post’s Wonkblog had a piece Thursday titled “This is why the Fed should start worrying about inflation again.” The main bit of evidence is a graph attributed to Kevin Logan showing a negative relationship between the unemployment rate and increasing rates of inflation. But this graph actually says far less than Mui says. 

Indeed there is a relationship between unemployment and inflation. The Federal Reserve is tasked with balancing inflation and unemployment, and when the Fed fears inflation, it raises interest rates with the intent of slowing the economy and creating unemployment. To some extent, then, the relationship is the Fed’s doing.

Let us put that aside, however, and take the observed relationship at face value. First, it is far from obvious that 6.5 percent unemployment represents a threshold below which inflation is as likely to rise as fall– particularly given the small sample size. In Figure 1, I was unable to reproduce exactly Logan’s figure, but according to data available at the Fed, four of the five years with the highest unemployment rates under 6.5 percent are associated with decreasing inflation.

Figure 1: Unemployment and Changes in Inflation
cepr blog rosnick 2014-03-07c

Source: FRED, series JCXFE and UNRATE and author’s calculations

Rather than cherry picking, we may regress changes in inflation against the unemployment rate. As it turns out, the relationship is statistically weak. The expected change in inflation switches between positive and negative somewhere between 2.5 and 7 percent. Likewise, this suggests that the 50/50 point lies closer to 5 percent than 6.5.

Table 1: Regression results

 

(1)

(2)

(3)

  β0

constant

0.52 (0.37)

0.52 (0.43)

0.52 (0.39)

  β1

unemployment rate

-0.11 (0.06)#

-0.11 (0.07)

-0.11 (0.06)#

 

variance/covariance estimator

OLS

jackknife

bootstrap

                    -  β0/ β1

2.6-7.1

2.9-6.8

3.0-6.7

# significant at 10percent level

Source: FRED, series JCXFE and UNRATE and author’s calculations

In Figure 2, we see the probability that inflation will be higher in 2014 than it was in 2013– assuming various year-round average unemployment rates for 2014. At 6.5 percent unemployment, the probability is closer to one in three than one in two.

Figure 2: Probability of Increased Inflation in 2014
cepr blog rosnick 2014-03-07a

Note: The widest (lightest) confidence band covers 95 percent of outcomes and the most narrow (darkest) band covers 50 percent.

Source: FRED, series JCXFE and UNRATE and author’s calculations

More importantly, increasing inflation is the wrong consideration. The Fed has tolerated inflation below 2.0 percent ever since 2007, and in 2013 core inflation ran only 1.2 percent. If the Fed must target some rate of inflation, it should target a higher rate of inflation. Yet, even if the relationship is meaningful then there is less than a 5 percent chance that 2014 inflation will run even as high as 2.0 percent.

Figure 3: Probability of At Least 2% Inflation in 2014
cepr blog rosnick 2014-03-07b

Note: The widest (lightest) confidence band covers 95 percent of outcomes and the most narrow (darkest) band covers 50 percent.

Source: FRED, series JCXFE and UNRATE and author’s calculations

To the extent that the relationship is both meaningful and a result of Fed activity, then, this suggests that meeting a 2% inflation target would require the Fed to be less hawkish than would be normal for the rate of unemployment. It may yet be some time before the Fed raises interest rates.

 

 

 

 

Comments (1)Add Comment
...
written by Jim, March 08, 2014 10:00
LOL--In a comment on today's blog post, "In the Real World the Trade Deficit Is More Important Than the Budget Deficit," I made a comment about the media's lack of responsibility in reporting, and this article demonstrates exactly what I mean about that as it relates to the reporter's bona fides. The media is not responsible enough to hire people who are capable of writing on a given topic, or sit on an editorial board and review the "information" they will pass on to their readers/viewers as credible insight, to wit:

Ylan Q. Mui is a financial reporter at The Washington Post covering the Federal Reserve and the economy. Prior to that, she wrote about subprime lending, consumer finance, retail and education. Ylan is a graduate of the Asian American Journalists Association’s Executive Leadership Program and former vice president of the AAJA’s Washington D.C. chapter. She was also an adjunct journalism professor at the University of Maryland. Ylan graduated from Loyola University in New Orleans with a major in communications and a double minor in biology and philosophy.

http://www.washingtonpost.com/2011/03/09/ABTPHIQ_page.html

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