Low Inflation Explained

By Dr. Duru written for One-Twenty

March 8, 2006


In January, I asked why inflation seems so low as reported in the official numbers in light of the abundant inflation pressures I see all around me. Roger W. Ferguson, Jr., the vice chairman of the Federal Reserve, offered an explanation in his speech at Howard University on America's economic outlook (March 3, 2006). Essentially, he claims that the economy has become less energy "intensive" - that is, we use less energy to get the same economic output than we did say 30 years ago. But he also claims that the Fed has done a good job of managing expectations of long-term inflation down to lower levels. This latter explanation worries me because it suggests that the dynamic of inflation has a large psychological component...it seems that we can fight real inflationary pressues simply by willing it downward. This argument seems to be on eof exclusion: all other possible explanations seem to be ruled out, leaving this one in play. I am still not completely convinced, but I thought I would alert you to decide for yourself. The important section is copied below.

Also note that in this speech, Ferguson makes the case that the inversion of the yield curve does not portend future economic weakness. But the caveat is that he suggests that long-term interest rates are too low. Be careful on this one! It means again suggests that the Fed may increase short-term rates longer than we currently think. This time, in order to finally force longer-term rates higher. As I mentioned in the last missive, this scenario has not been priced into the prices of stocks like those of the homebuilders, not to mention the expectations of the executives, so the presumed bottom in housing stocks is looking more and more tenuous. In fact, Beazer (BZH) and Meritage (MTH) have sounded the alarm by convincingly breaking below presumed support on Tuesday.

As always, be careful out there!

Vice Chairman Roger W. Ferguson, Jr. talks on the inflation outlook at Howard University (March 3, 2006):

The continued surge in energy prices was the dominant factor affecting inflation last year. Rising energy prices contribute to consumer inflation in several ways--by boosting prices for gasoline and other energy goods; by raising the price of non-energy goods and services as firms pass on increased energy costs; and by putting upward pressure on expectations of future inflation. Despite those pressures, core inflation has, as I mentioned, remained contained, a result likely attributable to a range of causes.

The decline in the economy's energy intensity is one of the factors that has restrained the pass-through of energy prices into core inflation in recent decades. As energy prices started to rise in the 1970s, households responded by purchasing products that were more energy efficient and adjusting their consumption habits in other ways. Businesses responded by designing and purchasing capital goods that were more energy efficient and by redesigning production processes in ways that used less energy. One measure of these changes in energy intensity is the ratio of energy use to real GDP, which has fallen more than half since the mid-1970s.

Econometric evidence suggests, however, that the pass-through of energy prices to core inflation has dropped by more than would be implied by the decline in energy intensity. In particular, we often look at forecasting equations for core inflation that include a term for the price of energy, weighted by a measure of energy intensity. Using data for years preceding 1981, the pass-through of energy prices to core prices is large and statistically significant. In the period since 1981, the evidence of pass-through of energy prices to core inflation is more limited. Because the energy-price term in these models already controls for the decline in energy intensity, this result suggests that other factors also are restraining the pass-through of energy prices to core inflation.

Although many factors could have led to these results, a likely explanation is that inflation expectations have become better anchored. In the 1970s, monetary policy unfortunately allowed large increases in energy prices to have a persistent effect on inflation, a policy that undercut the Fed's credibility and caused long-run inflation expectations to be more volatile. Since that time, however, the Federal Reserve has been more aggressive in fighting all sources of inflationary pressures, including energy price changes. This effort appears to have paid off not only in low and stable inflation but also in a reduction in the sensitivity of long-run inflation expectations to energy prices. The reduced sensitivity is evidenced by how little movement has appeared in survey measures in response to the rise in energy prices over the past two years.

This same tendency can be seen in longer-horizon measures of inflation compensation derived from a comparison of yields on nominal Treasury securities and those on Treasury inflation-protected securities (TIPS), which are indexed to a measure of price change. Specifically, for the period five to ten years ahead, the TIPS-based measure of inflation compensation has remained well anchored in recent quarters. Moreover, econometric evidence suggests that since early 2004, energy prices have had only a modest effect on TIPS-based inflation compensation at relatively longer horizons. Because inflation-indexed securities were not issued in the 1970s and early 1980s, we cannot know for sure how these recent effects differ from those that might have operated earlier, but I believe that the difference would be stark.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

DrDuru, 2006