40% Chance of Delfation: A Fed Non Sequitur

Lou Brien |

We’re all on board with the idea that the Fed is going to hike the funds rate in December, right? Of course we are. That’s because when the FOMC last met in October, most meeting participants already anticipated that conditions to raise rates would be met by December – and that was before the recent jobs data came up aces. The Fed chatter lately does nothing to dissuade us from that view. And besides, a number of policymakers worry that any further delay in liftoff could cause more trouble than its worth.

So let’s ditch the zero bound ASAP; that was the less than subtle hint in the last FOMC statement, the part where they said they just needed to determine “whether it will be appropriate to raise the target range at its next meeting…” The “next meeting”, December, a few weeks hence; not some meeting a considerable time from now, nor will the decision require patience, the “next meeting”, nudge/nudge, wink/wink.

The Fed looks ready to go; so why not? For one thing, the unemployment rate is down at 5.0% and payrolls have grown by an average of more than 200k for four years. And for another thing, the probability of deflation is only forty percent or so….

What?!?!?! What did I just write? Deflation is a forty percent probability? Seriously? Why would I write such a thing? It’s a silly idea, out of step with the Fed drift; up current in a financial world that wants to finally get downstream; it’s a non sequitur if ever there was one.

The chart below is meant to anticipate the probability of deflation in the next twelve months. In August, the chance of deflation sometime in the next year was less than one percent, but in September and October the probability is closer to forty percent. But…but…the Fed…zero bound in the rear view…arghhh.


Back-off! Don’t blame me, it’s not my idea. A few economists over at the St. Louis Fed, are just trying to be helpful. A couple of weeks ago, on November 6, the St. Louis Fed introduced the Price Pressures Measure (PPM), a new model used for forecasting the future path of inflation.

“In January 2012, the Federal Reserve joined many other central banks in adopting a numerical inflation target: two percent over the medium term. Monetary policy tends to affect the economy with a lag, so prudent monetary policymaking in an inflation-targeting regime requires a forecast of future inflation over the medium term.

The Federal Reserve, like most central banks, devotes considerable resources to monitoring and analyzing large volumes of economic data and forecasting key economic series such as inflation. The problems and questions associated with forecasting future inflation have been well studied, including which measure of price level to forecast and whether to use one particular forecasting model, average across several models, or simply use the consensus of professional forecasters.

Policymakers usually want to know—to the extent possible—the probability that inflation over the next four or eight quarters will exceed the inflation target. Or, if inflation is very low, they may also want to know the probability that inflation will fall below zero (deflation)…

To help policymakers, financial market participants, and others who have an interest in assessing future inflation probabilities, the Federal Reserve Bank of St. Louis has developed an index called the price pressure measure (PPM).”

So the model uses nine main categories that in total comprise 104 separate data series.

As you can see from the table below there are twenty-three bits of data from the CPI report, another seventeen items that track inflation expectations, eleven derived from the labor market, and so on.


Additionally, the economists identify the three most important factors within each of the nine categories listed above, such as the 30-year TIPS spread, the unemployment rate, import prices and the Atlanta Fed’s sticky CPI.

It’s not clear which factors were behind the surge in deflation probability in September compared to August, or why the data stuck in October; but it is pretty clear that something happened. (I have reached out to the St. Louis Fed to see if one of the authors could help, but no word yet on the cause; I’ll let you know when I hear back…should be any second now…well, go ahead, you read on and I’ll wait here on hold.)

The PPM models track both the CPI and the PCE, the charts shown here are for the headline reading of the PCE, because that is the Fed’s target measure. Back in 2009, this inflation measure was below zero for seven consecutive months; March through September. In December 2008, this back tested PPM model showed deflation probability to be at seven percent. By January 2009, however, the probability of deflation jumped to 77%, two months before the first negative reading for the PCE. The index was very volatile for the rest of the year; as high as 65% in August, the month before the last negative PCE. You can see it on the chart below. For reference sake I will tell you that so far in 2015 the PCE year on year rate has been as low as 0.2% and as high as 0.3%. The range for PCE in 2014 was 1.8% at the top and 0.8% at the low.


I am not sure what to make of the St. Louis Fed’s Price Pressures Measure. I’ll keep an eye on it and see how it does over time. But clearly I don’t know what Janet Yellen or Stanley Fischer, or anyone else at the Fed thinks of it. If the Fed Chair has seen it, did she have to stifle a giggle, or did it cause some nervous laughter? All I know for sure is that the release of the St. Louis Fed PPM is at the very least awkward messaging. The Fed is just weeks away from executing its first rate hike in nine years, a move that the FOMC has taken great pains to foreshadow, without seeming to guarantee. So do you think the FOMC was hoping for a little something that muddies the water at this stage of the game?

(Gee, if only one of the regional banks could put out some research that throws into question the logic of a rate hike; something that suggests exiting the zero bound at this time is the exact wrong thing to do…wouldn’t that be great!!)

Yeah, probably not.

Oh, by the way, the PPM is not just for deflation, but its also used to predict the probability that the PCE will average more than 2.5% over the next twelve months. Currently, the chance of that happening, well, it’s zero; that’s what the chart below indicates.



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