Did we predict well 2010 inflation in the U.S. five years ago?

In 2005, we published two papers on inflation [1,2] where we first introduced a new concept deterministically linking the rate of price change, π(t), and the change in the level of labor force, dLF/LF. The first model was as follows [2]:

π(t) = 4. dLF(t-2)/LF(t-2) - 0.03

where π(t) is the GDP deflator and LF(t-2) is the level of civilian labor force two years before. Using several labor force projections made by the CBO (2004) and the BLS (2005) we obtained a prediction of inflation at a horizon of 10 years. Figure 9 below is borrowed from [2] and illustrates the original prediction.

Figure 9. Predicted inflation rate for the period between 2006 and 2016 according to the CBO’s (2004) labor force projection. A deflationary period starts in 2012.

We found that the period of the “Great Moderation” was approaching its natural end. The labour force projections made by CBO (2004) undoubtedly indicate a decrease in the participation rate and a decaying growth rate of the working age population. According to these projections, staring from 2010, the annual increase in labour force will be less than 1,200,000 – the value separating inflation and deflation. Hence, the year of 2012 is likely to mark the beginning of the deflationary era in the USA (which hopefully is the global disaster the Mayans talked about) because of the two-year lag between the labour force change and inflation.

Five years later we can compare our prediction with actual observations. (This is a mandatory step to validate any scientific theory. (In this sense, no mainstream macroeconomic theory is a scientific one.) Figure 2.29 is borrowed from our monograph and compares the prediction based on the CBO’s projection of the labour force and observations. After peaked at 3.2% in 2007, the rate of price inflation has been at a gradual decrease in striking agreement with our calculations. Notice that this prediction was actually made “on the back of a napkin” five years ago.

In 2010, we expect the overall price inflation (GDP deflator) at the level slightly below 1%. It will be very instructive to compare our forecast for 2010 with the estimate of the BEA which will be available in couple months.

Figure 2.29. Predicted inflation rate for the period between 2006 and 2016 according to the CBO’s (2004) labour force projection. A deflationary period starts in 2012.

References

1. Kitov, I. (2006). Inflation, unemployment, labor force change in the USA, Working Papers 28, ECINEQ, Society for the Study of Economic Inequality, http://ideas.repec.org/p/inq/inqwps/ecineq2006-28.html

2. Kitov, I., (2006). Exact prediction of inflation in the USA, MPRA Paper 2735, University Library of Munich, Germany, http://ideas.repec.org/p/pra/mprapa/2735.html