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Inflation Watch

Yellen Concerned Fed Model Fails to Predict Price Moves

By April 27, 2014No Comments

Federal Reserve Chair Janet Yellen is concerned that the standard models central banks use to forecast inflation may be broken.

Behind her disquiet: the failure of the models to foresee the path of prices in the U.S. during the last recession and its aftermath and in Japan during its deflationary period from 1998 to 2012. U.S. inflation has been higher than the simulations suggested, while Japanese price declines proved more persistent.

Yellen alluded to her concerns in a speech last week, saying the Fed has to “watch carefully” to see if inflation picks up as the central bank projects — and hopes — during the next few years.

Standard computer models rest on two main pillars in trying to forecast longer-run price pressures: the amount of slack in the economy, usually measured by unemployment, and inflation expectations.

The higher the joblessness rate is above its so-called natural rate, the harder it is for employees to win pay increases and for inflation to accelerate. Yellen pegs that natural rate — at which price increases neither speed up nor slow down — at 5.2 percent to 5.6 percent. Unemployment in March was 6.7 percent.

Most Fed policy makers see inflation climbing to 1.5 percent to 2 percent by the end of next year and 1.7 percent to 2 percent at the end of 2016, according to projections released on March 19.

(Source: Bloomberg)