As discussed, low inflation is a phenomenon exhibited in many developed economies around the world, and this is driving central banks to cut core cash rates, in an attempt to move inflation into a policy band which is typically 2-3%.
Yet, inflation seems to be staying lower for longer. A new working paper from the IMF “What is Keeping U.S. Core Inflation Low” uses bottom-up analysis to try and identify the underlying causes of low inflation. They conclude that sizable elements which drive inflation outcomes are related to the international price of goods, and that this global linkage has been one of the major factors in driving inflation lower. In other words, globalisation explains much of the current lower inflation. Therefore we, perhaps, need to question underlying assumptions about what the right inflation target should be. 2-3% may not be relevant any more, and monetary policy needs to be reviewed.
Over and above the potential non-linearity of the Phillips curve, another key element of the current conjuncture is global concerns about low inflation. One way of seeing how this may be impacting the U.S. is to look at the very different trends in core PCE goods and services inflation.
Core services inflation declined through the 1990s from close to 5 percent to 2 percent, climbed again in the 2000s to reach 3.4 percent on the eve of the Great Recession, but then fell significantly during the Great Recession. It has recovered since then, but at around 2 percent remains significantly below levels seen earlier. Core goods inflation, on the other hand, has often been negative over the last twenty years, likely reflecting the impact of global pressures
Indeed, core goods inflation seems to react to nonpetroleum import prices with a lag, and the latter have been on a downward trend since late-2011.
Aggregate analysis only allows a limited understanding of the channels by which global pressures are impacting U.S. inflation. Moreover, it does not really facilitate the analysis of sector-specific factors such as the impact of the Affordable Care Act (ACA) on healthcare inflation. To really understand how external, domestic, and idiosyncratic factors drive the different components of inflation, one needs to develop a structural or “bottom-up” model, which is the goal of this paper. Specifically, we develop models of inflation for import prices, core goods, healthcare services, housing services, and core services excluding healthcare and housing. We then combine these models into one for aggregate PCE inflation. The overall findings of the paper are:
- Core goods inflation is driven mainly by global price pressures and dollar movements. Domestic factors (e.g. the unemployment gap) help explain core services inflation, and it is important to separately model housing and healthcare
sub-components of services inflation.- The aggregate inflation forecasts from this “bottom-up” approach have small root mean square errors (RMSEs), although the RMSEs using an aggregate Phillips curve equation are also small. The former, however, is more informative in tracing the effects of shocks and understanding the exact channels through which they affect overall inflation.
- When we use the bottom up model for forecasting inflation in 2016 and beyond, our benchmark scenario has inflation gradually rising towards but not reaching 2 percent by 2020, given the headwinds caused by global price pressures. This benchmark scenario uses the Congressional Budget Office’s (CBO) forecast for the unemployment gap (which troughs at around -0.4 percent in 2017 before starting to increase and turning positive in 2019), assumes the dollar remains constant in nominal effective terms, house price inflation remains around levels of late 2015, and the impact of the public spending cuts on health care inflation gradually declines.
- Core PCE inflation could, however, reach as high as 2.4 percent by 2018 if the dollar were to depreciate, the unemployment rate goes well below the natural rate, house price inflation climbs, and there is a more temporary impact of public spending cuts on health services inflation.
- These forecasts assume inflation expectations stay well anchored. If inflation expectations do become unanchored, then of course inflation could rise more rapidly and reach a higher level. This, however, seems a very unlikely scenario. The forecasts also assume the absence of non-linearities in the Phillips curve, which is empirically supported by our recursive analysis and direct tests.
Price changes in PCE core goods and core services have evolved differently over the past few decades. This motivated us to look deeper into inflation dynamics and investigate whether the underlying determinants of core goods and core services inflation also differ.
Our empirical work indicated that that this is indeed the case. In particular, we found that foreign rather than domestic factors drive core goods inflation, with a specific channel operating through import prices. The latter were, in turn, found to be primarily determined by the strength of the dollar as well as inflation in countries that are major non-oil commodity exporters of to the U.S.—most notably, China, Canada, the Euro area, and Mexico.
Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate.The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, itsExecutive Board, or IMF management
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