Price deflation in Switzerland?

We have already presented several empirical quantitative models of price inflation in developed countries in this blog. Our major result is the existence of a long-term equilibrium link between price inflation and the rate of change of labour force. Statistically, these two macroeconomic variables are cointegrated in such countries as the USA, France, Canada, and Austria. In some countries, e.g. the UK and Japan, the length of reliable data is too short for cointegration tests to be significant. However, cumulative inflation is accurately predicted in all countries.

Switzerland is one of the most important (although a middle size one) world economies. The country's statistics is characterized by relatively lengthy observations of labour force (Figure 1) and inflation (Figure 2). Apparently, the labour force series has two breaks: one in 1974 of unknown nature and one in 1991, as the OECD (2008) informs:

Series breaks: From 1998, data are adjusted in line with the 2000 census. Prior to 1991, data refer only to persons who are gainfully employed at least six hours per week.

The link between inflation and labour force also has a break around 1987, as Figure 3 depicts. Same effect was observed in Austria, where the change in the link is completely explained be the introduction of the ILO definition of labor force and unemployment instead of national ones. Linear regression of the observed series on the predicted one is characterized by slope 0.74, free term 0.003, and R2=0.82. According to the well-know problem with OLS, the slope is underestimated. Otherwise, the agreement is excellent. We did not use the cumulative curves for the estimation of coefficients in the linear link between labor force and inflation for Switzerland since corresponding time series are not long enough to provide a robust estimate. Fortunately, the original inflation curve (CPI) oscillates with a significant amplitude, and one only needs to fit the peaks of the oscillations in order to find appropriate coefficients, as shown in the Figure.

Hence, we have price inflation defined by a linear function of labor force with both coefficients changing in 1987:

CPI(t)= 1.1*dLF(t-2)/LF(t-1) + 0.005, before 1987

CPI(t)= 2.0*dLF(t-2)/LF(t-1) + 0.055, after 1987

It is worth noting that the predicted curve has two segments and covers the period between 1967 and 2008. All in all, the predictive power of the model is good and timely fits major peaks and troughs. Because the lag between the change in labor force and inflation is two years one can foresee the change in prices at this time horizon. In Switzerland, one should not expect high price inflation since the level of labor force has not been growing fast enough during the last two decades. It is very likely that inflation will be very low or even negative (deflation) in Switzerland over the next decade due to demographic problems and ageing population.

Figure 1. The rate of labour force change in Switzerland according to national definition (NAC) and the definition adopted in the US.

Figure 2. Two definitions of the rate of price inflation in Switzerland: GDP deflator and CPI inflation according to OECD definition.

Figure 3. Upper panel: The rate of CPI inflation in Switzerland as predicted by the  model with a structural break neat 1987 related to the change in measuring units. Notice that the predicted series is smoothed with MA(3). Lower panel: Linear regression of the data in the upper panel.