The FRB, the BEA, and the BLS lie on inflation. Update

Two years ago we posted on the federal funds rate and demonstrated that the Federal Reserve has been retaining an extremely simplistic approach when formulating its monetary policy. Figure 1 depicts the cumulative values of effective rate, R, and the rate of consumer price inflation, CPI, multiplied by 1.4. In the long run, these two curves evolve along the same trend and intercept every fifteen to twenty years. In December 2013, the cumulative R was approximately 20 points higher that the cumulative 1.4CPI. With the currently low rate of inflation in consumer prices, it will take another few years for the headline CPI to intercept the cumulative R curve. This means that R will be very low in the years to come, likely through 2020.  

We presumed that the main idea to keep R above the rate consumer price inflation is that a higher funds rate should suppress price inflation due to the effect expensive money. On the other hand, the FRB has likely to retain the interest rate at the long term level of price inflation in order to create neutral conditions for money supply. This would be a wise prerequisite for a central bank.  Then why the FRB needs that factor of 1.4? Actually it does not and the answer comes from the historical GDP data.  The problem of the multiplier is in wrong estimates of inflation since 1950. Essentially, the FRB, the BEA, and the BLS all lie.

Figure 2 depicts the evolution of real GDP per capita in the US since 1970. As we have already mentioned in our posts, there are two trends in the historical GDP data – before and after 1950. Before 1940, the (red) regression line with a slope of ~$61 per year in Figure 2 provides a good approximation of the actual curve. After 1950, the actual curve evolves along a straight line with a slope of $387 per year, i.e. the slope rises by a factor of 6.34 after 1950. Real GDP is defined as the ratio of nominal GDP and the GDP deflator. Both values are measured and estimated (also using a subjective hedonic factor) by the BEA and BLS. Therefore, the estimates of real GDP per capita heavily depend on the definition of price inflation. 

Let’s suppose that the real GDP curve evolves along the old trend after 1940, as shown in Figure 2. Then the level of real GDP per capita in 2008 would have been $10,774 instead of $31,178 as estimated by. This means that the GDP deflator was underestimated by a factor of 2.89 (=31178/10774).  The reported increase in the level of consumer prices since 1960 was of 7.27, i.e. CPI(2008)/CPI(1960) =7.27.  Then we expect that the actual price increase (i.e. reported plus underestimated) would have been 7.27+2.89=10.16, and the rate of CPI inflation was underestimated by 10.16/7.27=1.4 times.

This is exactly the factor of the federal funds rate above the rate of price inflation.  Hence, the FRB retains the interest rate at the level of actual inflation and thus does not influence inflation. The BEA, BLS and FRB lie (intentionally or not) about the rate of inflation and the growth in real GDP. The current level of GDP per capita in the US should be around $11,000 not $31,000.  

Figure 1. Cumulative values of the monthly estimates of R and the CPI multiplied by a factor of 1.4.

Figure 2. Historical estimates of real GDP per capita.

Is abenomics working?

Here we present  quantitative evidences that the effect of abenomics on CPI in Japan is invisibly weak, if any. Our quantitative model, which we presented at the conference “Inflation Developments after the Great Recession” hosted (December 2013) by the Deutsche Bundesbank and sponsored by the EABCN, is available as a CEPR working paper “Inflation, Unemployment, and Labor Force: The Phillips Curve and Long-term Projections for Japan”.   This model shows that the current surge in consumer prices is  an abenomics achievement, but the result of labour force increase started in 2011, i.e. before the start of the new monetary (and economic) policy introduced by Abe. Moreover, when the effect of increasing labour force fades away in a few months deflation in consumer prices will be back. It is worth noting that the GDP price deflator is still in the negative zone and that the headline CPI is a highly biased (up) measure of inflation not to be used by sane researchers.

 

At first, we present our model in detail. In this blog, we have already mentioned that Japan is the best illustration of our concept linking inflation/unemployment to the change in labour force. In our previous posts on the GDP deflator in Japan, we showed two cumulative curves for observed and predicted inflation since 1980. Here we revisit similar CPI curves also two more readings and conclude that our concept is quantitatively excellent. The underlying data have been borrowed from the OECD and Japan Statistics.

 

Using stata9 and allowing a structural break, we sought for the best-fit (in RMS sense) coefficients in the linear and lagged link between inflation and labour force. Because of the structural (measurement related) break in the 1980s, we have chosen the period after 1981 for linear regression, which is common for almost all economic studies related to Japan. By varying the lag and coefficients we have found the following relationship for consumer price inflation (CPI):

 

CPI(t) = 1.39dLF(t-t₀)/LF(t-t₀) + 0.0004            (1)

 

where the time lag t₀=0 years; Figure 1 depicts this best-fit case. There is no time lag between the inflation series and the labour force change series in Japan. Free term in (1), defining the level of price inflation in the absence of labour force change, is close to zero but negative.

 

A more precise and reliable representation of the observed and predicted inflation consists in the comparison of cumulative curves (a version of CUSUM technique) shown in the lower panel of Figure 1. We always stress that the cumulative values of price inflation and the change in labour force are the levels of price and labour force, respectively. Therefore, the summation of the annual reading gives the original estimates of price and workforce, which when are converted into rates.

 

Another advantage of the cumulative curves is that all short-term oscillations and uncorrelated noise in data as induced by inaccurate measurements and the inevitable bias in all definitions are effectively smoothed out. Any actual deviation between these two cumulative curves persists in time if measured values are not matched by the defining relationship. The predicted cumulative values are very sensitive to free term in (1).

 

For Japan, the CPI cumulative curves are characterized by very complex and unusual for economics shapes. There was a period of intensive inflation growth and a long deflationary period. The labour force change, defining the predicted inflation curve, follows all the turns in the measured cumulative inflation with the coefficient of determination R²=0.99. The predicted and observed cumulative CPI curves are cointegrated and thus this estimate is consistent. For the annual estimates: R²=0.73. With shrinking population, and thus, labour force, the level of CPI will be falling through 2050 and likely beyond.

 

Now, we return to the current rise in the headline CPI and apply (1) to monthly readings of labour force and inflation. Figure 2 shows the change rate in labour force. One can observe the positive trend started in the middle of 2011 and will likely extend into the first quarter of 2014. Figure 3 compares the predicted and observed rate of inflation (year-on-year estimates for the monthly estimates) since 2010 and demonstrates that the current rise in the headline CPI is likely a short deviation from the long-term trend fully related to a small rise in the level of labour force, not the abenomics tools. Because of the overall ageing and depopulation this positive trend will not last long and the level of labour force will definitely fall. This fall will induce price deflation, as Figure 1 predicts.  

 

 

Figure 1. Measured CPI inflation and that predicted from the change rate of labour force in Japan. Upper panel:  Annual curves smoothed with MA(3). Lower panel: Cumulative curves between 1981 and 2012. The extremely accurate agreement between the cumulative curves illustrates the predictive power of our model. The cumulative curves are I(1) processes and we thus it was instructive to test them for cointegration. This test was successful.

Figure 2. The rate of change in labour force, dLF/LF, since 2010. Monthly readings are used and the year-on-year rate is calculated. 

Figure 3. Comparison of the measured inflation rate (y-o-y) and that predicted from the change in labour force.

Towards cheaper food and energy in 2014-2016

We found sustainable linear trends in the difference between the headline and core CPI in 2007. We also were the first to suggest that the trend between 2002 and 2008 to be reversed to the opposite after an extended period of strong fluctuations. These findings are currently validated by five years of observations – the studied difference is on a sustainable linear trend since 2011. When extended into the second part of the 2010s, this trend implies that the joint consumer price of food and energy will be falling against other consumer goods and services in the headline CPI.

We have been routinely reporting on the difference between the headline and core CPI since 2008. Figure 1 illustrates our general finding that this deference can be well approximated be a set of linear trends. The last trend likely finished in 2009. That’s why we expected a new trend to evolve since 2011 into the late 2010s.

The U.S. Bureau of Labor Statistics has reported the estimates of various consumer price indices for December 2013. Figure 2 shows the predicted trend and the actual difference since 2002. The studied difference has been fluctuating around the zero line between in 2009 and 2011 and then showed a turn to the early predicted trend (Figure 3).  Essentially, the zero difference suggests that the core and headline CPI are practically equal and evolve at the same monthly rate, i.e. the joint price index of energy and food has been following the price index of all other good and services (the core CPI) one-to-one.  

Currently, the price index of energy slowly falls together with oil price. We expect them to fall deeper and thus the headline CPI to decelerate a bit together with energy. If the core CPI will retain its current cohesion with the headline CPI, we will have a period of very low inflation in all goods and services less energy and food. 

Figure 1. Two trends in the difference between the healine and core CPI.

Figure 2. The evolution of the difference between the core and headline CPI since 2002. 

Figure 3. The evolution of the difference between the core and headline CPI since 2010.