So, there's little evidence now of inflationary pressures

TO BE NOTED: From Econbrowser:

"In Search of ... Hyperinflationary Expectations

With large budget deficits in place and projected going forward, as well as the expansion of the Fed's balance sheet, there's been some talk of inflationary pressures, and even hyper-inflation [0] McCain. I wondered if these fears were manifested in survey- and market-based expectations measures.

For certain, there is little pressure apparent in short term forecasts like the WSJ and Survey of Professional Forecasters. This makes sense (at least if one believes in the Keynesian conception of an output gap [1]) given the amount of slack displayed in Figure 1.

Figure 1: Median expected ten year inflation recorded as of second month of each quarter, from Survey of Professional Forecasters (blue, left scale), actual CBO-defined output gap (red line), and WSJ forecasted (purple triangle), in log percentage points. NBER defined recessions shaded gray; second recession assumed to end 2009Q3. Source: Cleveland Fed, BEA, GDP 2009Q1 advance release, and WSJ May survey [xls], and CBO potential GDP (9 January 2009).

I also plot the median expectation of ten-year inflation. Note that this measure has not budged much at all.

This data, of course, will not convince those skeptical of survey-based measures. What about market based measures? The standard approach is to subtract the TIPS yield from the Treasury yield. We know for a variety of reasons, this calculation can lead to misleading results. However, the Cleveland Fed has stopped publishing its adjusted series:

October 31, 2008

We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.

With that caveat in mind, Figure 2 displays the implied ten year expected inflation rate.

Figure 2: Difference between ten year constant maturity Treasury yields and ten year constant maturity TIPS, monthly data. Series GS10 and FII10. Source: St. Louis Fed FRED.

Some people are looking to commodity prices as indicators of expected inflation. I'd say that making inferences this way is fraught with difficulties, because changes in such commodity prices will incorporate both relative price and price level effects.

So, there's little evidence now of inflationary pressures. That being said, there's plenty to worry about as time goes on (as Jim recounts). And even if inflationary expectations remain well anchored, we do have to keep an eye on possible crowding out due to higher interest rates (all of us, except Dick Cheney, who didn't ever worry about deficits as the Bush Administration ran up trillions in debt [3]).

Posted by Menzie Chinn "

In other words, we are only willing to lower our forecasts when we see bad news and the news keep being worse than what we expected

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy:

"The difficulty of forecasting around turning points

If forecasting in normal times can already be difficult, doing so during times when the phase of the cycle is changing becomes a real challenge. The amount of uncertainty increases as one can consider scenarios that are very far apart. When in 2007 we saw growth rates decreasing we needed to make a call on whether a recession was coming and if it was, how deep and large the recession was going to be.

This uncertainty has been reflected in the forecasts that we have seen about the state of the economy in the last 18 months.

What is interesting about these forecasts is not only that they are hard to make (and that they might turn to be completely wrong) but, in addition, they keep getting more and more pessimistic. In other words, we are only willing to lower our forecasts when we see bad news and the news keep being worse than what we expected so the forecasts are being revised downwards. So it is not just a matter of uncertainty, which could show up as alternating large positive and negative errors. We can think of this process of revising forecasts downwards as a bias in the way we produce our forecasts as the errors are always in the same direction: we are anchored by the past and always too optimistic about the sate of the economy [Strictly speaking, this might not be bias, it could truly be that we receive a string of bad news about the state of the economy that cannot be forecasted, but it is also likely that the consistency of the errors is a sign of our inability to accept that the news are as bad as they look].

Below is a chart with the forecasts for GDP growth rates for 2009 for the World and the US economy as produced by different vintages of the World Economic Outlook (by IMF). Starting with the forecast produced in the fourth quarter of 2007 and until the most recent forecast, we see that the forecast has gone down every single quarter (except for the first).

It is also interesting that forecast errors tend to be highly correlated across different forecasters. The picture below is from an early study about the accuracy of IMF World Economic Outlook (WEO) forecasts (same source as the chart above). The picture shows that there is a strong and positive correlation between the forecast errors of the WEO and the Consensus Forecasts errors - another common source of macroeconomic forecasts.

And here is a third similar picture with the forecasts of the unemployment rate for the US. Starting in the fourth quarter of 2007 I have plotted the forecast done by the Survey of Professional Forecasters of the unemployment rate 6 quarters ahead. We can see the line shifting upwards signaling a continuous update of expectations, always in the direction of increased pessimism. [The data come from the Federal Reserve Bank of Philadelphia]

In summary, our forecasts keep getting worse before they get better! And whenever we find the new turning point –the bottom of this recession- it is likely that we see a similar pattern but in the opposite direction. Forecasts might remain too pessimistic for a while and are only revised upwards as a continuous set of good news improves our views on the economy.

Antonio Fatás"