St. Louis Fed: “0% probability that inflation will average more than 2.5% over the next 12 months”

Laura E. Jackson, Kevin L. Kliesen, and Michael T. Owyang of the St. Louis Federal Reserve have constructed a new measure they call the price pressures measure (PPM).

According the authors the “PPM measures the probability that the expected inflation rate (12-month percent changes) over the next 12 months will exceed 2.5 percent”…the PPM is constructed “for both the consumer price index (CPI) and personal consumption expenditures price index (PCEPI).”

This is how the PPM is constructed:

In technical terms, the PPM index is constructed from an ordered probit model that is augmented with nine “factors.” A factor-augmented model is a common method of incorporating a large amount of data in a parsimonious fashion. The nine factors, comprising 104 separate data series, are grouped in the following categories: (1) consumer price indexes, (2) producer price indexes, (3) commodity prices, (4) housing and commercial property prices, (5) labor market indicators, (6) financial variables, (7) inflation expectations, (8) business and consumer survey data, and (9) foreign price variables.

The ordered probit model provides probabilities that inflation will exceed 2.5 percent, on average, over the next 12 months. But the model also allows us to assess the probability that inflation will average something different. In our original article we structured the model to assess the probability that inflation will fall within one of four bins: less than zero (deflation); 0 percent to 1.5 percent; 1.5 percent to 2.5 percent; and more than 2.5 percent. We could also assess probabilities for other outcomes. For example, we could condense the second and third bins into one, leaving three sets of probabilities: Inflation will be less than zero (deflation) over the next 12 months, inflation will average between 0 percent and 2.5 percent, and inflation will be greater than 2.5 percent.

So what is the measure saying now?

Well, the message is very clear – this is what the authors say: “As of October 2015, the PPM predicts a zero percent probability that PCEPI inflation will average more than 2.5 percent over the next 12 months.”

This is obviously wrong – we can never say that there is a zero percent probability of anything, but ok this is the kind of result you sometimes get from probit models. That however, is not the important thing, but rather the key message here is that there is very little likelihood that Fed will overshoot it’s inflation target in the coming next 12 months. In fact it is very clear that the likelihood of deflation is higher than inflation being above 2.5% in 12 months.

Therefore you gotta ask yourself why does St. Louis Fed president James Bullard continue to argue for the Fed to hike rates? After all the research done by his own research department tells him that he rather should worry about deflationary risks.

PS See the original paper on the Price Pressure Measure here.

PPS Scott Sumner should be delighted that Laura E. Jackson recently became an assistant professor at Bentley University.

Jim, it is not complicated – NGDP tells you NOT to hike

This is what St. Louis Fed president James Bullard today told CNBC:

“there’s a powerful case to be made that it’s time to raise interest rates. And the case is not complicated. … Policy settings are [in] an emergency. The economy itself, the goals of the committee, have essentially been met.”

Bullard goes on to talk about the labour market and talk about low oil prices is helpful for the US economy. It all very much sounds like Bullard has made up his decision BEFORE he has looked at any data.

In fact it is hard to see what monetary policy rule Bullard is advocating and he seems to be cherry picking data to make an argument for rate hike. It is frankly speaking not very impressive.

But why doesn’t Bullard just look at nominal GDP? After all back in May he co-authored a Working Paper in which he essentially argued that the Federal Reserve should to target nominal GDP!

So lets have a look at how nominal GDP has been developing:

NGDP has since mid-2009 essentially been on a straight line growing on average slightly less than 4% a year and in Q2 2015 was slightly below this trend.

Why doesn’t Bullard just acknowledge that? He should be happy – the Fed is doing what he said it should be doing. But of course that would mean that there would not be any arguments for hiking interest rates. After all prediction markets (such as Hypermind) presently are forecasting around 3.5% NGDP growth for all of 2015 and in that sense the Fed is slightly undershooting it’s post-2009 de fact NGDP rule.

Jim, I was very happy to see you advocated NGDP targeting back in May – why have you already changed your mind??

PS Bullard talks about interest rates being at “emergency” setting. I guess Bullard has forgot what Milton Friedman told us about why low interest rates. Jim, interest rates are low because monetary policy has been tight.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.