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Friday, November 18, 2005

St. Louis Fed President Poole on Tracking Inflation

William Poole, president of the St. Louis Fed, discusses how the Fed tracks and forecasts inflation in conducting policy. He also talks about his view of current inflation trends and says "...the FOMC has tightened its policy stance considerably." and "... core inflation and inflation expectations have been contained, but underlying determinants of inflation suggest caution." Here are excerpts from the speech:

Tracking Inflation, by William Poole, St. Louis Fed President:  ...I have said previously that I favor a goal of zero inflation, properly measured. In practice, because of various statistical problems in measuring prices, that goal translates, approximately, to price changes of something like a 1 percent annual rate of increase in the chain-price index for Personal Consumption Expenditures—the PCE ... for short. In its day-to-day policymaking, the Fed focuses on the core PCE price index, which excludes volatile food and energy prices... On average over time, the total and core indexes change at almost identical rates. Even putting volatile food and energy prices aside, it is not possible to achieve an inflation target precisely year by year; thus, my goal might be stated as a change in the core PCE index of 0.5 to 1.5 percent per year. That range itself needs to be a bit elastic to allow for special circumstances that might be important in a particular year. ... I believe that all of us have in mind inflation goals that are so close one to the other that differences in the goal are not really an issue. However, there is an important issue that I struggle with every time I go to an FOMC meeting: What policy will yield an outcome close to the inflation goal? ...

How does the Fed control inflation as successfully as it does? The Fed extracts as much information as it can from all the data and anecdotal reports available. An important aspect of this work is to track the inflation process—the internal dynamics of the inflation rate. That is my main topic today. ...  In a 2005 paper, James Stock and Mark Watson, using data through the end of 2004, conclude:

  1. that inflation has become “easier” to forecast, in the sense that models have low forecast errors because inflation rates have been low and stable. And
  2. that inflation has become “more difficult” to forecast in the sense that the contribution to the forecast of variables other than lags of inflation has largely vanished.

On balance, Stock and Watson’s results tell us that “tracking inflation” has become easier than it was a decade ago—because the rate is lower and varies less—but also is more difficult because future inflation is far less sensitive to measures of real economic activity. ... Forecasts presented to the FOMC by its staff combine model-based information with judgment. ... judgment is critically important. Policymakers often have to act “observation by observation,” evaluating incoming data and responding to events. ... Inflation-tracking involves tracking market expectations of inflation and a careful analysis of wage trends, productivity and profit margins. ...

Current Inflation Developments ...I’ll close with a brief discussion of the current inflation environment. Energy prices are the big story. ... To date, it appears that little of the energy price increase has bled over into core inflation. .... My prediction that little of the energy price inflation will bleed into core inflation is based on my belief that inflation expectations are well-anchored and ... that the FOMC has tightened its policy stance considerably. Moreover, the FOMC has a clear commitment to price stability, and that leads me to believe that the Committee will adjust its policy stance in the future as required by incoming information. If new information calls for further tightening—and I emphasize the “if” because I do not have a crystal ball that permits me to predict incoming information—then that is what the FOMC will do. ...[H]igher energy prices are a change in relative prices that will inevitably lead to changes in other relative prices... Energy price increases will affect other prices, at least for the medium-term, but should have little impact on longer-run inflation expectations. ... What are these data saying? ...[T]he ... figures suggest the market has considerable faith in the FOMC’s commitment to price stability. The Survey of Professional Forecasters and the University of Michigan’s Survey of Consumer CPI inflation expectations yield similar results. ...

Putting all these indicators together, core inflation and inflation expectations have been contained, but underlying determinants of inflation suggest caution. Depending on what measure is used, wage change has been about steady or has risen. The profit share of GDP has risen, suggesting that firms have increased pricing power. Fortunately, productivity growth remains robust. ...

[Bloomberg also discusses the speech.]

    Posted by on Friday, November 18, 2005 at 12:06 AM in Economics, Fed Speeches, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (1)

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