Methods for Evaluating Recent Trend Inflation
The Federal Reserve’s Federal Open Market Committee (FOMC) has set a long-run objective for consumer price inflation of 2.0 percent. However, most measures of inflation in the US have declined over the past year and are running consistently below this objective. For example, in February, the year-over-year percent change in the Consumer Price Index (CPI) was just 1.1 percent, and the percent change in the CPI excluding food and energy (core CPI) was just 1.6 percent. One measure of inflation that has been relatively steady around 2 percent is the median CPI produced by the Federal Reserve Bank of Cleveland. However, the higher rate of inflation in the median CPI is driven largely by the Owner’s Equivalent Rent (OER) component of the index. If this component is omitted, inflation in the median CPI (excluding OER) was 1.5 percent in February, following a trajectory similar to that of core CPI inflation.
The FOMC’s preferred inflation indicators, which are based on the Personal Consumption Expenditures (PCE) price index, have also been persistently below 2.0 percent. In January, the most recent month for which data are available, the year-over-year percent change in the PCE price index was 1.2 percent, and the percent change in the core PCE price index was 1.1 percent. Each of these indicators has been running below 2.0 percent since early in 2012. More broadly, inflation in the core PCE price index has been consistently below 2.0 percent since the middle of the most recent recession, apart from a few months in the beginning of 2012.
The long-running pattern of core PCE inflation falling short of 2 percent raises a fundamental question: has the longer-term trend rate of inflation declined, or are we simply experiencing an extended period of inflation running below its unchanged trend? Trend inflation can be thought of as the rate of inflation that would be expected to prevail if there were no temporary factors, such as a level of economic activity below the economy’s potential, influencing the inflation rate. Put another way, trend inflation is the inflation rate that we would expect after temporary factors subside.
There are a number of ways to measure or estimate trend inflation. Different approaches can be reasonable because, with the available data, it can be difficult to distinguish a change in trend from a persistent deviation of inflation from the trend. One model might attribute a long-running change in inflation to a change in the trend, while another attributes the change to a persistent deviation of inflation from an unchanged trend. Both models may nonetheless predict a similar path of inflation in the future.
Recent research (see Clark and Doh 2014) compares how well different models or measures of trend inflation fare in forecasting inflation from 1975 through 2012. Several measures stand out for forecasting relatively well, yet they are quite different. We apply three of these measures to quarterly data through 2013:Q4 to assess what each says about whether trend inflation may have declined in recent years and what each implies for the inflation outlook.
3 Measures of Trend Inflation
One approach to measuring trend inflation is to define it as the long-run forecast of professional forecasters. The forecast used is the 1-10 year ahead average inflation forecast from the Survey of Professional Forecasters (SPF). By this measure, trend inflation has remained stable: the survey estimates of long-run inflation haven’t changed much in recent years. This definition of trend inflation implies that the recent decline in inflation is a persistent deviation from an unchanged trend, rather than a change in the trend itself.
A second approach to quantifying trend inflation relies on a simple statistical model that decomposes inflation into a trend component and noise—very temporary deviations from trend (see Stock and Watson 2007 for details). According to this approach, trend inflation has fallen noticeably. However, the estimate of trend from this model has been quite variable over time, and it tends to move somewhat in line with actual inflation. As a result, by this method the recent disinflation looks to be caused by both the decline in the trend and temporary deviation from it.
A third measure of trend inflation comes from a model that decomposes inflation into a trend component and somewhat persistent deviations from trend (see Cogley and Sargent 2005 for details). Estimates of the trend from this model fall somewhere in between those of the first two measures. By this measure, trend inflation has moved down gradually in recent years. So, like the second approach, this one implies that recent low inflation is the result of both a lower trend inflation rate and a temporary fall of inflation below the trend.
Implications for the Inflation Outlook
Overall, these three trend inflation measures are a bit like the choices facing Goldilocks when she wandered into the home of the three bears: one measure implies trend inflation has changed very little, another that it has fallen by a little, and the third that it has declined by relatively a lot. Since they all have been similarly successful in predicting future inflation in the past, it is not easy to say which will give the most accurate forecast going forward. They do imply slightly different outlooks for inflation over the next few years.
Let’s start with the forecasting approach that defines trend inflation as the long-run forecast of professional forecasters. In the model that uses this measure of the trend, inflation depends on this trend and past departures of inflation from the trend. This specification yields a forecast of PCE inflation gradually rising over time to about 2 percent and a forecast of CPI inflation rising slightly above 2 percent. This is not surprising given that the inflation trend estimated by this method has been stable around these levels.
The models based on the other two trend inflation estimates yield forecasts that are relatively flat around the recent estimate of the trend rate, with the forecasted inflation rate from the model with the smoother trend (using the third measure) a bit higher than the forecasted rate from the model with the most variable trend (using the second measure). Putting all of this together, by any measure we have considered, recent inflation trends suggest inflation is likely to remain low in coming quarters.
We have considered only a few of the ways that trend inflation can be estimated. Though simple, the models we have considered are competitive in terms of forecast accuracy with more sophisticated models that include information on more than just inflation. Still, the models we have considered are limited in that they do not include other information on some of the factors that may impact inflation over the business cycle, such as employment and wages. Other recent research, such as Clark and Zaman 2013, which uses forecasting models that include a broader set of indicators, has projected a gradual rise in inflation toward 2 percent.
Clark, T.E., and Doh, T. (2014). Evaluating Alternative Models of Trend Inflation. International Journal of Forecasting, 30, 426-448.
Clark, Todd E., and Zaman, Saeed (2013). Forecasting Implications of the Recent Decline in Inflation. Federal Reserve Bank of Cleveland, Economic Commentary.
Cogley, T., and Sargent, T.J. (2005). Drifts and Volatilities: Monetary Policies and Outcomes in the Post-World War II US. Review of Economic Dynamics, 8, 262-302.
Stock, J.H., and Watson, M.W. (2007). Has US Inflation Become Harder to Forecast? Journal of Money, Credit, and Banking, 39, 3-33.