U.S. Economy: The Outlook for Inflation - Expand Your Insight

"A Fresh Look at the National Economy," In Depth, November 1998 (PDF)

"Is Unemployment Too Low?" Southwest Economy, Nov./Dec. 1998 (Text or PDF)

U.S. Economy
The Outlook for Inflation

Dallas Fed Economists Evan F. Koenig and John V. Duca provide a forecast for inflation and discuss the factors that can affect it.

The current expansion is nearly eight years old. If it continues through February 2000, it will match the expansion of the 1960s. More and more, the 1960s are the standard against which this economy must be compared. Chart 1 plots the unemployment rate and GDP price inflation, with shaded areas indicating recessions. Both unemployment and inflation are at their lowest levels since the days of bell bottoms, granny glasses and tie-dyed T-shirts. But will this trend for inflation continue?

Chart 1

The outlook for inflation depends on a variety of factors. Probably the most important factor is the inflation expectations that are built into labor contracts. Ideally, we would recognize that these expectations depend on past and anticipated future money growth. In practice, economists often approximate inflation expectations by taking an average of past actual inflation. Other factors affecting inflation include labor-market slack (measured by the unemployment rate), supply disruptions originating in the volatile food and energy sectors (as reflected in movements in the relative prices of food and energy), and global competition (as reflected in the price of imports relative to the price of domestically produced output).

Chart 2

Predicting movements in inflation has proved difficult, because movements in food, energy and import prices are themselves difficult to predict. For example, much of the downward drift in inflation over the past several years—which has caught most economists by surprise—can be attributed to unexpected declines in the relative price of imports. Chart 2 shows actual four-quarter changes in the GDP price index along with the forecasts generated by a model that factors in past inflation, labor market slack, food and energy shocks, and import prices. For the reasons just discussed, the model tends to overpredict inflation in recent years, but the errors are generally not large. Our forecast for inflation over the next four quarters is 1.3 percent, just slightly above the 0.9 percent rate we’ve seen over the past four quarters. Chances are 50 percent that inflation will lie between 0.75 percent and 1.75 percent, and the odds that inflation will turn into outright deflation or that inflation will exceed 2.5 percent are each less than 1 in 20. The average private forecaster is not quite so optimistic—he's expecting inflation to accelerate to a 1.7 percent annual rate.

Evan F. Koenig and John V. Duca are both senior economists and vice presidents at the Federal Reserve Bank of Dallas.

SUGGESTED CITATION:
Duca, John and Evan Koenig (1999), "The Outlook for Inflation," Federal Reserve Bank of Dallas Expand Your Insight, February 1, http://www.dallasfed.org/eyi/usecon/9902inflation.html