An examination of how to assess the inflationary effects of current monetary policy, reviewing the behavior of a selected measure of core inflation over the past decade and contrasting this pattern with the inflation expectations of both households and professional forecasters, concluding that such expectations are formed rationally.Inflation (Finance)

John B. Carlson

English

Research Papers in Economics

May 15, 1994
eCONOMIC
COMMeNTORY
Federal Reserve Bank of Cleveland
Assessing Progress toward Price
Stability: Looking Forward and
Looking Backward
by John B. Carlson
We will be at price stability when
households and businesses need not
factor expectations of changes in the
average level of prices into their deci-
sions. How those expectations form is
not always easy to discern, and they
can for periods of time appear to be at
variance with underlying economic
forces. But history tells us that it is eco-
nomic and financial forces and their
consequences for realized inflation that
ultimately shape inflation expectations.
Alan Greenspan
1
inflation, as measured by the rate of
change of the Consumer Price Index
(CP1), has slowed substantially in recent
years. Since 1990, it has averaged less
than 3 percent, compared with an average
rate of about 5 percent in the previous
three years (see figure 1). Similarly, other
measures, designed to exclude transitory
special factors and focus on the so-called
core or underlying rate of inflation, have
also slowed to around 3 percent. From
the perspective of this rear-view mirror,
it seems evident that the deceleration in
prices has stopped, as both measures
have tended to stabilize around the re-
cent lower mean levels.
Survey data on inflation expectations of
households and professional forecasters,
on the other hand, suggest that not all of
the decline is permanent and that the
price level will tend to rise slightly over
the coming year. Although survey data
provide some forward-looking element,
the problems associated with measuring
inflation expectations are well known.
The high cost of obtaining information
via surveys limits their scope and fre-
quency. Ascertaining the appropriate in-
formation with the right questions is
difficult, and imperfect survey methods
invariably lead to sampling error.
Nevertheless, policymakers cannot al-
ways depend on the rear-view mirror as a
guide to where the price level might be
headed. Traditional economic thinking
holds that the impact of monetary policy
affects inflation only with a significant
lag. Thus, an overly stimulative policy
stance may not become evident until it is
too late to be turned around without
wrenching consequences.
Such a situation is sometimes likened
to a freighter with a full head of steam.
The captain must take actions well in
advance if he is to alter the course of
the ship and avoid treacherous shoals.
The experience of the 1970s, when
double-digit inflation rates reigned, is
typically offered as a case in point of
the failure of policy to act preemp-
tively. Most analysts agree that appro-
priate countermeasures were not taken
soon enough.
The purpose of this Economic Com-
mentary is to examine more closely the
problem of assessing the inflationary
effects of current policy. I first describe
how a selected measure of core infla-
tion excludes potential transitory ef-
fects. I review the behavior of this
measure since 1982, then contrast the
pattern of core inflation with house-
Inflation moderated in the early 1990s,
as revealed by the Consumer Price In-
dex and measures of core inflation. Sig-
nificant changes in inflation have been
infrequent and rather abrupt over the
past decade and have coincided with
similar changes in inflation expecta-
tions. Although survey data from both
consumers and professional forecasters
suggest that expected inflation has been
an unbiased predictor of future infla-
tion, recent experience indicates a per-
sistent overprediction. Nevertheless, the
timing between changes in actual and
expected inflation implies that both are
driven by the same factors; that is, ex-
pectations are formed rationally.
hold expectations one year ahead. Al-
though their mean inflation expecta-
tions have historically been unbiased,
households have overpredicted infla-
tion in recent years. The survey data of
professional forecasters reveal a simi-
lar, albeit less pronounced, tendency.
• Core Inflation
Core inflation measures are generally de-
signed to extract the long-run, or perma-
nent, component of the measured price
index by filtering out transitory special
factors. For example, food and energy
components of the CP1 are subject to peri-
odic supply shocks that produce rela-
tively large but short-lived (although
sometimes persistent) shifts in the index
ISSN 0428-1276that are unrelated to more permanent
changes. Although food and energy are
among the more volatile components
of the CPI, other comparably volatile
components remain in the core infla-
tion measure; thus, the CPI excluding
food and energy is somewhat arbitrary.
One alternative measure of core infla-
tion proposed in a recent Federal Re-
serve Bank of Cleveland study does
not preselect any particular sectors for
exclusion.
2 Rather, it is calculated by
trimming the outlying portions of the
cross-sectional distribution of the compo-
nents of aggregate price indices in each
month. Thus, it does not single out any
sector as the primary source of transitory
distortion for all periods. More specifi-
cally, the authors consider a trimmed
mean that represents the weighted aver-
age of the central 85 percent of the price-
change distribution. They chose the 15
percent trimmed mean because it had the
smallest monthly variance of all estima-
tors of this type.
Figure 2 illustrates core inflation as
measured by the 15 percent trimmed
mean since 1982, along with trend
rates of change within selected subperi-
ods. Statistical change-point methods
have identified these as periods in
which the mean inflation rate is essen-
tially fixed and deviations from the
mean are random and independent
from period to period.
1 One implica-
tion of these results is that the best
guess of inflation in any period is its
mean value in that period.
The success of this measure in exclud-
ing transitory special factors is best
highlighted when contrasted with the
behavior of the CPI around 1985-86
(see figure 1). At that time, the dip in
the CPI was largely held to be the re-
sult of a transitory decline in oil prices.
The 15 percent trimmed mean showed
no such downturn.
Although the trend in the core measure
has changed since 1982, the statistical
change-point procedures find that such
shifts have been infrequent and rather
abrupt. Core inflation first accelerated
moderately around May 1988, then fell
FIGURE 1 INFLATION AND CORE INFLATION OVER
PREVIOUS 12 MONTHS
Percent
16
CPI inflation
I
1969 1974 1979 1984 1989 1994
SOURCES: U.S. Department of Labor. Bureau of Labor Statistics: and the Federal Reserve Bank of Cleveland.
FIGURE 2 CORE INFLATION, 1983-94
Percent change, annual rate
1983 1985 1987 1989 1991 1993 1995
NOTE: Numbers above solid rules indicate central tendency. Numbers in parentheses are standard deviations
of central tendency.
SOURCE: Federal Reserve Bank of Cleveland.
sharply between January and February
1991—at the same time the Persian
Gulf War was resolved, eliminating a
great deal of uncertainty about the fu-
ture of oil prices.
4
Interestingly, the variability of core in-
flation around means within periods
tended to rise and fall with the mean
level of change. The standard deviation
of core inflation since 1991 has been
less than 1 percentage point, suggest-
ing that inflation has fallen in some per-
manent sense to rates not seen since the
mid-1960s.
• Household Inflation Expectations
The Survey of Consumers conducted by
the University of Michigan asks house-
holds what they expect the inflation rate
to be over the following 12 months.
Although the responses have at times
been at odds with realized inflation,
household forecasts have generally
been unbiased.
5 Figure 3 reveals that
from early 1983 to 1991, household in-
flation expectations were, on average,FIGURE 3 ONE-YEAR-AHEAD INFLATION EXPECTATIONS:
MICHIGAN SURVEY MEAN, 1983-94
Percent change, annual rate
1987 1983 1985
NOTE: Solid rules indicate central tendency.
SOURCE: University of Michigan, Survey of Consumers.
1989 1991 1993 1995
FIGURE 4 ONE-YEAR-AHEAD INFLATION EXPECTATIONS:
PHILADELPHIA SURVEY, 1983-94
Percent change, annual rate
5.5
1983 1985 1987
NOTE: Solid rules indicate central tendency.
SOURCE: Federal Reserve Bank of Philadelphia.
consistent with trend rates within sub-
periods delineated by change points in
the core inflation measure. Although
expectations fell sharply in early 1991,
the average expected inflation rate has
exceeded actual trend rates since then.
Relatively permanent changes in house-
hold inflation expectations coincided
closely with substantial and abrupt
changes in the mean of core inflation,
such as between May and June 1988
and between January and February
1991. The latter break occurred pre-
1989 1991 1993 1995
cisely at the climax of the Persian Gulf
War. It appears that such events can
trigger a watershed change in expecta-
tions.
6 In the four or five years prior
to the Gulf War victory, price pressures
had been building. Although a series of
policy actions had been taken to con-
tain and even reduce inflation, house-
holds remained unconvinced and were
generally correct: Inflation advanced at
higher rates until the conflict ended.
The timely resolution of the war and
the prospect for permanently lower oil
prices may have been a turning point
for the inflation outlook.
The coincidental nature of changes in
both expected inflation and actual core
inflation suggests that households did
not anticipate the timing of these
changes. Had they done so, expected
inflation would have changed less
abruptly and would have begun falling
prior to the decline in the actual core
rate. Moreover, the coincidence in tim-
ing is consistent with the idea that
household expectations have been ra-
tional, responding to the same factors
that determine actual prices. What is
curious is that households have not
been persuaded that lower levels of in-
flation since early 1991 are permanent.
• Expectations of
Professional Forecasters
The Federal Reserve Bank of Philadel-
phia conducts a quarterly survey of pro-
fessional forecasters on their expecta-
tions for inflation over the next four
quarters. Historically, surveys of pro-
fessional economists have tended to ex-
hibit some bias.
7 The series compiled
by the Philadelphia Fed beginning in
1983, as shown in figure 4, indicates
that these respondents have been more
upbeat than households about the infla-
tion outlook.
As is true with household surveys
(though to a lesser extent), large changes
in the expectations of professional fore-
casters appear to coincide with breaks in
the core inflation series. Professional
forecasters tended to anticipate the change
point in 1991, however, as the series be-
gan to descend more than a year earlier
than did actual inflation. Nevertheless,
they too have overpredicted inflation dur-
ing the past two years.
• Concluding Thoughts
Substantial and rather abrupt changes
in core inflation since 1982 have gener-
ally been accompanied by significant
changes in the inflation expectations of
both households and professional fore-
casters. The coincidence in timing sug-
gests that these expectations are driven
by the same factors that determine ac-
tual changes in the price level; that is,expectations are formed rationally. The
implication, of course, is that well-
articulated policies can influence infla-
tion expectations. To the extent that
such policies are credible, they can re-
duce the inflation premiums built into
interest rates and the adjustment costs
that result when inflation rates change.
Although this article has examined a
limited sample of available survey data,
the recent discrepancy between ex-
pected and actual inflation is a matter
of some concern. The fact that house-
holds have generally been unbiased in
their predictions suggests that actual in-
flation will adjust to expected levels,
rather than the other way around. Look-
ing forward has, in this sense, been
more reliable than looking backward.
• Footnotes
1. Hearing of the Economic Growth and
Credit Formation Subcommittee of the
House Banking, Finance, and Urban Affairs
Committee, February 22, 1994.
2. See Michael F. Bryan and Stephen G.
Cecchetti, "Measuring Core Inflation," Fed-
eral Reserve Bank of Cleveland. Working
Paper No. 9304. August 1993. Although the
authors describe a class of "limited informa-
tion" measures, we consider a particular
member of this class to illustrate a point.
3. See Edward Bryden and John B. Carlson,
"On Disinflation since 1982: An Application
of Change-Point Tests," Federal Reserve
Bank of Cleveland. Economic Review, vol.
30, no. 1 (1994 Quarter 1), pp. 31-42.
4. Although Bryden and Carlson (footnote
3) report a subsequent reduction in core infla-
tion around March 1992, the test indicates no
break when the sample is extended to include
the most recent data and is adjusted with re-
vised seasonal factors.
5. See Michael F. Bryan and William T.
Gavin, "Models of Inflation Expectations
Formation: A Comparison of Household and
Economist Forecasts," Journal of Mone\,
Credit, and Banking, vol. 18, no. 4 (Novem-
ber 1986). pp. 539-44.
6. For a more extensive discussion of this con-
jecture, see Bryden and Carlson (footnote 3).
7. See Bryan and Gavin (footnote 5).
John B. Carlson is an economist at the Fed-
eral Reserve Bank of Cleveland. The author
thanks Jean Mclntire for research assistance.
The views stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, Ohio 44101
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Assessing progress toward price stability: looking forward and looking backward

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