The Fed and Inflation Expectations
Rarely a day goes by when we do not see a complaint about inflation and the Fed. Some observers feel that the Fed will soon be forced to recognize their special insight–something that they know about inflation, but the Fed and the market do not.
Since current data are backward-looking and the Fed Open Market Committee is concerned about inflation expectations, the question of how to analyze inflation is quite important. Predictions about future inflation are the best guide to Fed policy.
Professional Inflation Forecasts
The Econocator site is relatively new, but posts a lot of interesting and objective information on economic indicators, including this interesting study (hat tip to Abnormal Returns for the typical great job in citing important links).
The study looks at various econometric methods of forecasting inflation but concludes that opinion surveys do better than the forecasting methods. So what do the forecasts show now?
A check of the Livingston Survey shows that consensus opinion of those forecasters has the CPI gaining 2.6% in 2007 over 2006 and 2.3% in 2008 over 2007. Checking the Survey of Professional Forecasters shows a forecast in core PCE inflation (the Fed’s favorite measure) of 2.1%, year-over-year, for each of the next three years.
There are three important conclusions from this information:
- The expectation of future inflation is close to the Fed’s comfort level.
- If the study findings are correct, these explanations are also the best prediction.
- There is little evidence that inflation is spiraling out of control.
The current debate seems to center on core CPI versus headline CPI. We will look at this specific issue more carefully in another article.
For the moment, the prediction that the Fed is "on hold" with current policy seems most accurate. Astute investors interested in likely Fed actions should keep this in mind. The idea that the Fed has actually succeeded in achieving reasonable future growth and inflation, avoiding recession, is still a contrarian notion — one that offers great investment potential.