Macroblog

September 4, 2015

5-Year Deflation Probability Moves Off Zero

Since 2010, our Bank has regularly posted 5-year deflation probabilities derived from prices of Treasury Inflation-Protected Securities (TIPS) on our Deflation Probabilities web page. Each deflation probability, which measures the likelihood of a decline in the Consumer Price Index over a fixed five-year window, is estimated by comparing the price of a recently issued 5-year TIPS with a 10-year TIPS issued about five years earlier. Because the 5-year TIPS has more "deflation protection" than the 10-year TIPS, the implied deflation probability rises when the 5-year TIPS becomes more valuable relative to the 10-year TIPS. (See this macroblog post for a more detailed explanation, or this appendix with the mathematical details.)

From early September 2013 to the first week of August 2015, the five-year deflation probability estimated with the most recently issued 5-year TIPS was identically 0 as the chart shows.

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Of course, we should not interpret this long period of zero probability of deflation too literally. It could easily be the case that the "true" deflation probability was slightly above zero but that confounding factors—such as differences in the coupon rates, maturity dates, or liquidity of the TIPS issues—prevented the model from detecting it.

Since August 11, however, the deflation probability has had its own "liftoff" of sorts, fluctuating between 0.0 and 1.3 percent over the 16-day period ending August 26 before rising steadily to 4.1 percent on September 2. Of course, this rise off zero could be temporary, as it proved to be in the summer of 2013.

How seriously should we take this recent liftoff? We can look at options prices on Consumer Price Index inflation (inflation caps and floors) to get a full probability distribution for future inflation; see this published article by economists Yuriy Kitsul and Jonathan Wright or a nontechnical summary in this New York Times article. An alternative is simply to ask professional forecasters for their subjective probabilities of inflation falling within various ranges like "1.0 to 1.4 percent," "1.5 to 1.9 percent," and so forth. The Philly Fed's Survey of Professional Forecasters does just this, with the chart below showing probabilities of low inflation for the Consumer Price Index excluding food and energy (core CPI) from each of the August surveys since 2007.

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Although the price index, and the horizon for the inflation outcome, differs from the TIPS-based deflation probability, we see that the shape of the curves is broadly similar to the one shown in the first chart. In the most recent survey, the probability that next year's core CPI inflation rate will be low was small and not particularly elevated relative to recent history. However, the deadline date for this survey was August 11, before liftoff in either the TIPS-based deflation probability or the recent volatility in global financial markets. So stay tuned.

By Pat Higgins, senior economist in the Atlanta Fed's research department

• September 4, 2015 in
  • Deflation
  • Federal Reserve and Monetary Policy
  • Inflation
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August 10, 2012

Deflation Probabilities on Our Radar Screen

In the latest Wall Street Journal Economic Forecasting Survey, conducted August 3–6, economists were asked whether they "expect[ed] the Fed to start another round of large-scale bond buying in 2012?" Sixty-three percent answered yes, and 49 percent expected a program would be announced in September, presumably at the end of the next meeting of the Federal Open Market Committee (FOMC) on September 12–13. Obviously this question is of interest to more than just business economists. For example, at his July 17 testimony before the Senate Committee on Banking, Housing, and Urban Affairs, Sen. Mike Crapo asked Fed Chairman Ben Bernanke whether the FOMC should seriously consider more quantitative easing going forward. As part of his response, the Chairman said that "we would certainly want to react against any increase in deflation risk." The entire video exchange can be viewed at the 52–55 minute mark here.

As part of the Atlanta Fed's Inflation Project, we regularly update probabilities of deflation in the Consumer Price Index (CPI) estimated from Treasury Inflation-Protected Securities (TIPS) prices, described here and here. The basic idea is that a recently issued 5-year TIPS has less "deflation protection" than a 10-year TIPS maturing about the same date as the 5-year TIPS. The yield spread between the 5-year TIPS and 10-year TIPS can be used to help estimate the probability of deflation.

The most recent (August 8) estimate puts the 5-year probability of deflation from early 2012 to early 2017 at around 15 percent. As seen in the figure below this probability is up slightly from May, but only about half the readings of the 5-year (2010–15) deflation probability seen in the late summer and early fall of 2010 and considerably below readings seen during the height of the financial crisis in late 2008 and early 2009.

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It is important to note that these deflation probabilities are estimates based on a relatively simple model that uses a number of assumptions that not everyone may agree on. Jens Christensen, Jose Lopez, and Glenn Rudebusch at the Federal Reserve Bank of San Francisco have built an alternative model for estimating deflation probabilities that also uses TIPS yields. At the time of the publication of their paper in 2011, their model's probabilities were somewhat lower than—but highly correlated with—ours.

The TIPS market has a number of features that make inferring both inflation expectations and deflation probabilities from them tricky. Most notably, there are unknown liquidity differences between TIPS and nominal Treasury securities. A more direct way of estimating deflation probabilities—or in fact the entire probability distribution of future CPI inflation—using so-called inflation caps and floors has recently been explored by economists Yuriy Kitsul and Jonathan Wright. Inflation caps and floors are essentially options on the Consumer Price Index. We used the Kitsul and Wright method for constructing the implied probabilities of (annualized) CPI inflation over the next five years. As seen in the figure below, this method implies a 13 percent probability that inflation will be 0 percent or negative on average over the next five years. This probability is about at the midpoint of the range that prevailed between October 2009 and March 2012. (See figure 3, on page 29 of Kitsul and Wright's working paper.)

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As Kitsul and Wright explain, the market for inflation caps and floors is still quite small relative to the TIPS market. So the deflation probabilities from their model should be considered suggestive, as should our own.

What's the takeaway from all this? Well, readings from the financial market indicate the likelihood of a sustained deflation is currently about 15 percent, or a bit less. That's up from earlier in the year, but not nearly as high as in 2010.

Should we be concerned about the prospect for deflation in the years ahead? This is obviously an important policy question. But I'm not a policymaker; I merely put up the numbers for you to consider. And, of course, we will continue to follow these indicators closely—as can you. Our deflation probability estimates are updated every Thursday and posted on our Inflation Project.

By Patrick Higgins, an economist in the Atlanta Fed's research department

• August 10, 2012 in
  • Deflation
  • Inflation
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May 17, 2012

Is inflation targeting really dead?

Harvard's Jeffrey Frankel (hat tip, Mark Thoma) is the latest econ-blogger to cast an admiring gaze in the direction of nominal gross domestic product (GDP) targeting. Frankel's post is titled "The Death of Inflation Targeting," and the demise apparently includes the notion of "flexible targeting." The obituary is somewhat ironic in that at least some of us believe that the U.S. central bank has recently taken a big step in the direction of institutionalizing flexible inflation targeting. Frankel, nonetheless, makes a case for nominal GDP targeting:

"One candidate to succeed IT [inflation targeting] as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980's, since it did not share the latter's vulnerability to so-called velocity shocks.

"Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand—the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway."

That's certainly true, but a nominal GDP target is consistent with a stable inflation or price-level objective only if potential GDP growth is itself stable. Perhaps the argument is that plausible variations in potential GDP are not large enough or persistent enough to be of much concern. But that notion just begs the core question of whether the current output gap is big or small. At least for me, uncertainty about where GDP is relative to its potential remains the key to whether policy should be more or less aggressive.

In another recent blog item (also with a pointer from Mark Thoma), Simon Wren-Lewis offers the opinion that acknowledging uncertainty about size of the output gap actually argues in favor of being "less cautious" about taking an aggressive policy course. The basic idea is familiar. It is a simple matter to raise rates should the Fed overestimate the magnitude of the output gap. But with the short-term policy rates already at zero, it is not so easy to go in the opposite direction should we underestimate the gap.

No argument there. As I pointed out in a May 3 macroblog item, Atlanta Fed President Dennis Lockhart has said the same thing. But, as I argued in that post, this point of view is only half the story. Though I agree that the costs are asymmetric to the downside with respect to the FOMC's employment and growth mandate, they look to me to be asymmetric to the upside with respect to the price stability mandate. And I view with some suspicion the claim that we know how to easily manage policy that turns out to be too aggressive after the fact.

My issues are not merely academic. In an important paper published a decade ago, Anasthsios Orphanides made this assertion:

"Despite the best of intentions, the activist management of the economy during the 1960s and 1970s did not deliver the desired macroeconomic outcomes. Following a brief period of success in achieving reasonable price stability with full employment, starting with the end of 1965 and continuing through the 1970s, the small upward drift in prices that so concerned Burns several years earlier gave way to the Great Inflation. Amazingly, during much of this period, specifically from February 1970 to January 1977, Arthur Burns, who so opposed policies fostering inflation, served as Chairman of the Federal Reserve. How then is this macroeconomic policy failure to be explained? And how can such failures be avoided in the future?...

"The likely policy lapse leading to the Great Inflation …can be simply identified. It was due to the overconfidence with which policymakers believed they could ascertain in real-time the current state of the economy relative to its potential. The willingness to recognize the limitations of our knowledge and lower our stabilization objectives accordingly would be essential if we are to avert such policy disasters in the future."

With this historical observation in hand, it seems a short leap to turn Wren-Lewis's thought experiment on its head. Arguably, the last several years have demonstrated that nonconventional policy actions have been quite successful at short-circuiting the disinflationary spirals that pose the central downside risk when interest rates are near zero. (If you can tolerate a little math, a good exposition of both theory and evidence is provided by Roger Farmer.)

On the opposite side of the ledger, we know little about the conditions that would cause the Fed to lose credibility with respect to its commitment to its inflation goals, and very little about the triggers that would cause inflation expectations to become unanchored. Thus, I think it not difficult to construct a plausible argument about the risks of being wrong about the output gap that is exact opposite of the Wren-Lewis conclusion.

I end up about where I did in my previous post. Flexible inflation targeting, implemented in such a way that the 2 percent long-run inflation target rate exerts an observable gravitational pull over the medium term, feels about right to me. Despite what Frankel seems to believe, I think that idea is far from dead.

By Dave Altig, executive vice president and research director at the Atlanta Fed

• May 17, 2012 in
  • Deflation
  • Economic Growth and Development
  • Federal Reserve and Monetary Policy
  • Inflation
  • Monetary Policy
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March 23, 2012

Why we debate

It's been a while since we featured one of my favorite charts—a "bubble graph" comparing average monthly job changes during this recovery with average changes during the previous recovery, sector by sector.

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If you try, it isn't too hard to see in this chart a picture of a labor market that is very close to "normalized," excepting a few sectors that are experiencing longer-term structural issues. First, most sectors—that is, most of the bubbles in the chart—lie above the horizontal zero axis, meaning that they are now in positive growth territory for this recovery. Second, most sector bubbles are aligning along the 45-degree line, meaning jobs in these areas are expanding (or in the case of the information sector, contracting) at about the same pace as they were before the "Great Recession." Third, the exceptions are exactly what we would expect—employment in the construction, financial activities, and government sectors continues to fall, and the manufacturing sector (a job-shedder for quite some time) is growing slightly.

For the skeptics, I below offer a familiar chart, which traces the level of total employment pre- and post-December 2009, compared with the average path of pre- and post-recession employment for the previous five downturns:

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We are now more than 16 quarters past the beginning of the recession that began in the fourth quarter of 2007, and total employment is still 4 percent lower than it was at the beginning of the downturn. In the previous five recessions by the time 16 quarters had passed, employment had increased by about 6 percent. Even in the worst case, indicated by the lower edge of the gray shaded area, employment growth was flat—and that observation is qualified by the fact that the recovery from the 1980 recession was interrupted by the 1981–82 recession.

This unhappy comparison is not driven by the construction, financial activities, and government sectors. In the area of professional and business services, which has logged the largest average monthly employment gains in the current recovery, the number of jobs still sits 2.7 percent below the level at the outset of the last recession, as the chart below shows.

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Total private-sector jobs in education and health services, which never actually contracted during the recession, nonetheless remain abnormally low in historical context.

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In these charts lies the crux of some very basic disagreements about the appropriate course of policy. The last three graphs draw a clear picture of labor markets that are underperforming by historical standards—a position that I take to be the conventional wisdom. An argument against following that conventional wisdom centers on the question of whether historical standards represent the appropriate yardstick today. In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.

One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious. Measured inflation appears to moving in the direction of the Federal Open Market Committee's 2 percent long-term objective.

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Also, the Atlanta Fed's own monthly survey of business inflation expectations, which surveys a panel of businesses from our Reserve Bank district, indicates that this inflation number (shown in our March release from earlier this week) is in line with what private-sector decision makers anticipate:

"Survey respondents indicated that, on average, they expect unit costs to rise 2.0 percent over the next 12 months. That number is up from 1.9 percent in February and comparable to recent year-ahead inflation forecasts of private economists. Firms also reported that their unit costs had risen 1.8 percent compared to this time last year, which is unchanged from their assessment in February. Inflation uncertainty, as measured by the average respondent's variance, declined from 2.8 percent in February to 2.4 percent in March, the lowest variance since the survey was launched in October 2011."

Does that settle it? Not quite. There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn't over yet.

By Dave Altig, senior vice president and research director at the Atlanta Fed

• March 23, 2012 in
  • Deflation
  • Employment
  • Federal Reserve and Monetary Policy
  • Inflation
  • Labor Markets
  • Monetary Policy
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