Economists Lose Their Inflation-Forecasting Touch

Models show that prices ought to climb. Didn't happen in July. That's a problem.

Plenty to worry about.

Photographer: Andrew Harrer/Bloomberg

July was another month of very low inflation, we learned on Friday. That's too bad.

Economists had anticipated a small but respectable gain in the U.S. consumer price index. That would have relieved some pressure on the U.S. Federal Reserve to delay interest-rate increases in the name of economic growth.

The increase was indeed small at 0.1 percent in July from a month earlier; year-on-year, the advance was 1.7 percent. That's far from respectable. Once upon a time such glacial movement would have been considered a victory. Now, by missing estimates, it exposes the shakiness of traditional economic assumptions a decade after the global financial crisis began.

Unemployment, at 4.3 percent, is lower than the Fed considers sustainable over the long run and should be enough to generate significant wage gains. That, in turn, ought to push inflation toward, or beyond, the Fed's 2 percent target.

QuickTake Full Employment

Central bankers are rightly anxious about this. It's not just an American phenomenon. Across the developed world, labor markets are at, or close to, levels of joblessness so low that they qualify as full employment. Bank of Japan Governor Haruhiko Kuroda has chastised unions for being too timid about pressing for wage hikes. Reserve Bank of Australia Governor Philip Lowe wants workers themselves to demand more.

The figures released Friday by the Department of Labor are separate from the Fed's key price gauge, the Personal Consumption Expenditures index published by the Department of Commerce toward the end of each month. But they are indicative of price trends. At both headline and core level, the numbers this week showed an increase of 0.1 percent from June and 1.7 percent on the year. Core, which strips out volatile food and energy prices, has fallen short of estimates for a fifth consecutive month.

All Quiet on the Inflation Front

Year-over-year percentage change in U.S. Consumer Price Index

Source: Bloomberg

After briefly flirting with 2 percent in February, the PCE -- as the Fed's preferred measure is known -- has retreated. That shouldn't be happening, according to the Philips Curve, the model developed about six decades ago that links low levels of unemployment with rising pay and prices.

Most Fed officials, like a majority of their counterparts abroad, still firmly believe in the established forecasting models, which they think will prove accurate over time.

What if they're wrong? What if a barely perceptible increase like the one released Friday becomes a source of grudging celebration? 

It's not as if some Fed officials aren't questioning the need for the expected interest-rate increases if inflation stays below target. As St. Louis Fed President James Bullard told Kathleen Hays on Bloomberg Radio this week: "Misses add up over time. The markets wonder, do they really have an inflation target or not."

Perhaps the biggest problem with models like the Philips Curve is that they were developed before the financial crisis and the deep worldwide recession that followed. As Stephen Jen, a director of Eurizon SLJ Capital Ltd., told me last month in response to Lowe's exhortations, the global labor market changed irrevocably after China's entrance to the World Trade Organization in 2001. Labor is now a global marketplace.

Or maybe the problem is that, in the aftermath of the crisis, inflation and wage rises won't happen until the unemployment rate falls below even historic and supposedly theoretical lows.

It's one of the ways, big and small, that the crisis left its scars on the nation and the world. With the U.S. expansion now in its ninth year, inflation ought to be picking up. Such a pickup, if accompanied by acceleration in pay gains, would be an unambiguously good thing.

Job growth in the U.S. is impressive. It's a pity inflation can't keep up.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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