Inflation Outlook: Monetary Policy Implications

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Michael Acampora's picture

Inflation has remained depressed since the financial crisis in 2008, rarely meeting the Federal Reserve's 2% target. The consumer-price index recently rebounded from negative territory and is currently sitting slightly above zero, indicating flat prices from one year ago. With so much focus on when the Fed will initiate the first post-financial crises rate increase it is important to understand what is impacting inflation. In fact, Federal Reserve Bank of Chicago President Charles Evans cited low inflation as the main reason to hold off on raising the Fed funds rate until 2016. Utilizing the modern Phillip's curve, I will examine the three components that impact inflation: inflation expectations, the unemployment gap, and price shocks.


Inflation Expectations:

Inflation expectations can be measured by the difference between the U.S. Treasury bonds and Treasury Inflation Indexed Securities (TIIS) of varying maturities. For instance, looking at the 5-year maturity, the spread indicates inflation expectations of 1.56% as of March 25, 2015. On the same date, using the 20-year maturity, inflation is expected to be 1.98%-essentially at the Federal Reserves stated target. This indicates inflation is expected to be lower in the near-term, but gradually rising toward the 2% level. 



Unemployment Gap:

The unemployment gap is likely responsible for dragging down inflation during the post-financial crises period. The unemployment gap is measured by the difference between the unemployment rate and the natural rate of unemployment. Fortunately, with the steady employment gains the gap has closed significantly after a massive increase during the financial crisis. The unemployment rate as of February 2015 is 5.5% just 34 basis points greater than the natural rate of 5.16%. During the peak of unemployment in 2010, the gap exceeded 400 basis points-a significant drag on the economy. This small gap should not be significantly impacting inflation, as it is indicative of a healthy labor market.

However, another way to measure the health of the labor market and the unemployment gap is through wages. As the labor market becomes balanced, wages are expected to improve-indicating workers are able to demand higher wages without fear they will be replaced. Strangely, wage gains have been essentially non-existent, even with tremendous employment gains. Perhaps this is a result of the severity of the recession or hidden slack in the labor market (low labor force participation, people forced to work part-time). Either way, stagnant wages is not indicative of a healthy labor market. 



There is one thing encouraging on the wage front suggesting things may soon change- rising wage expectations. The University of Michigan Consumer Confidence Survey asks participants their expected income increase over the next 12 months. Although actually wage growth is essentially non-existent, wage expectations have recently surged. This will likely lead to an uptick in wages over the next 12 months, which would finally confirm the economy is near full employment. If wage growth does materialize, it places upward pressure on inflation.

Price Shocks:

If inflation expectations are stable, and the unemployment gap is closing, why is inflation so weak? The answer is in the last part of the modern Phillip's curve equation, price shocks. Anyone filling up their gas tank has noticed the huge fall in gas prices since the summer. In fact, the price of WTI crude oil has declined nearly 50% from July 2014. Since oil prices represent an important input costs throughout the economy, this massive decline results in a positive supply shock-reducing inflation. The timing of this supply shock has made assessing the health of the economy challenging. The resulting low inflation has puzzled many who expect accelerating labor market improvement to result in higher inflation.

Policy Implications:

The inflation rate is being dragged down in the short-term by the massive decline in oil prices, now that oil prices have stabilized it is likely inflation will move closer to the long-term trend of 2%. In fact, it is assumed in the long-run that the only factor impacting inflation is inflation expectations, this occurs because the unemployment gap over an extended period is zero. With stable expectations, a healthy labor market, and rapidly increasing wage expectations--the Fed should feel comfortable initiating the rate increase later this year. In fact, later this year may be the perfect time to raise rates before the economy overheats and inflation spikes.



Sources and Further Reading:

Inflation, New-Home Sales Firm Up:

Grand Central: New Signs of an Inflation Cycle Turning:


Hi Michael! I like your analysis of the factors that determine inflation rates. Especially liked the part where you connected it to policy implications. Just a quick question, have you considered the impact of the recent Iran deal on oil prices? And if not, how do you think that will affect your analysis of the inflation rate?

Thanks Abhimanyu. No I did not consider the implications of recent Iran deal when I originally wrote this a few moths back. From my understanding the relative impact of the deal will be small given the global supply of oil. However, it probably already has led to further decrease oil prices, putting downward pressure on inflation. In May, when I first started working on this article there were signs that inflation was beginning to rebound. This move has not continued, with recent data indicating persistently low inflation, which could put the Fed on hold for the first rate move.