Paul Krugman, after this piece admitting the general failure of economics, explains in here why inflation in Japan is very low (due to deflation expectations) and why the US will repeat all the way down. Except the future of the US inflation, i.e. deflation starting in 2012, there is no right explanation os the driving force behind price inflation. We explained the case of Japan five years ago, and predicted an extended period of deflation in the US six years ago.
The performance of 10-year T-notes during deflation
In our previous article we presented a prediction of an extended period of price deflation in the U.S. since 2012. Our projection was made in 2006 and covers the period between 2006 and 2016. At least five years are characterized by negative inflation. The underlying model can also foresee beyond 2016 when some updated labour force projections are used (see Appendix). There is no expectation of a positive inflation rate at least in the 2010s. Deflation is a major risk for the U.S. economy and stock market. Therefore, one can consider a safer investment in Treasuries. Let us check various options.
Currently (August 18, 2:15), T-notes and T-bonds have very low yields between 0.19% for 2-year T-notes and 3.55% for 30-year T-bonds. Since the predicted deflationary period will last at least 8-years one can choose between 7-year and 10-year T-notes. The former has the yield of 1.45% and the latter 2.15% (coupon 2.125%). Taking into account the predicted rate of inflation below -0.5% per year in the near future, one can evaluate the real yield as 3% in the next few years. This is a safe and relatively profitable investment during the poor years to come. The stock market will likely be stangnant if not decaying.
The BLS has projected the level of labour force to increase from 154.300.00 in 2008 to 167.000.00 in 2018, i.e. by 0.8% per year on average. Considering the current fall in the rate of participation down to 64.5% (instead of 66%) which was expected only in 2018, we should decrease the projected level in 2018 by approximately 1.2%, i.e. to 165.000.000. Then, the rate of labour force growth is 0.66% on average between 2008 and 2018. According to our model the rate of consumer price inflation is driven by the change rate in labour force:
CPI(t)=4.5dlnLF(t-3)/dt - 0.032 (1)
where CPI(t) is the rate of consumer price inflation at time t, LF(t-3) is the level of labour force three years before the predicted rate of inflation. Using the average rate of labour force change between 2008 and 2018 one can estimate the average consumer price inflation between 2008 and 2018 as -0.3% per year. Since the years between 2008 and 2011 have a positive inflation rate the years after 2012 will have evens a smaller average inflation rate. On average, I would estimate the future rate of inflation as -0.5% per year since 2012. However, during 2012 and 2013 it can be as low as -3%.
Deflation is a long term threat for the stock market
Price deflation in the U.S. is an issue which attracts attention. For example, the FOMC statement implies very low inflation at a two year horizon. The two-year breakeven inflation rate is negative. As a result, economics blogs are also full of discussions around the near future of the overall price behaviour. ( Despite the explicit FOMC statement many experts expect a period of hyperinflation after two sessions of quantitative easing.) The danger of deflation has been demonstrated by Japan where the quantitative easing did not show any positive results.
We predicted an extended deflationary period since 2012 five years ago. This prediction was based on a model describing inflation in developed countries as a linear and lagged function of labour force. In 2006, we published a forecast for the U.S. a ten year horizon using the following relationship:
DGDP(t) = 4.0dlnLF(t-2)/dt – 0.03 (1)
For 2011, the model predicts the rate of inflation near 0.4%. The current fall in commodity prices and the deceleration in real economic growth both imply no price inflation in the second half of 2011. Hence, our prediction for 2011 from 2006 seems to be right.
Between 2012 and 2016, the rate of inflation (as expressed by the GDP deflator) will be negative at the level between -0.5% and -1.2% (2013). Obviously, the CBO labour force projection at a ten year horizon could not be too precise and actual values of the future inflation rate may differ from the predicted ones. However, the negative inflation trend is a serious and long term danger for the U.S. economy.
Deflation in consumer prices is also predicted by the current measurements of labour force. We estimated a similar relationship for the headline CPI. Five years ago the following relationship was obtained:
CPI(t) = 4.5dlnLF(t-3)/dt – 0.032 (2)
The time lag of three years (actually 2.5 years) provides the best fit between observed and predicted values. In (2), the slope is larger than in (1). This difference expresses a larger volatility in consumer prices. Figure 2 illustrates the agreement between the observed and predicted rate of consumer price inflation between 1960 and 2010. At a three year horizon one can expect a significant fall in the rate of inflation, down to -4% per year. This is a great threat for producers, consumers and the U.S. economy as a whole.
The uncertainty in labour force measurements is directly mapped into high-amplitude fluctuations. These fluctuations represent banal measurement noise and can not be removed without improvements in the relevant BLS methodology and procedures. It is instructive that the largest fluctuations correspond to the years of decennial censuses. The Census Bureau has to smooth the difference between counted and projected population values (so called population controls) and the BLS ignores these steps. As usually, the most reliable readings correspond to the changes with the largest amplitude.
The best way to suppress this measurement noise is to use integral (cumulative) values. Figure 3 displays the observed and predicted cumulative inflation curves starting from 1965. The predicted cumulative curve is obtained by a progressive summation of values from 1963 and is also shifted ahead by 2 years. There is an almost complete agreement between the cumulative curves for the whole period. The only small deviation occurred around 1993 and corresponds to a sharp drop of the rate of labour force growth as induced by the baseline working age population correction.
Figure 2. Measured inflation and that predicted from the dLF/LF (shifted 2 years ahead). An agreement is observed throughout the whole period with some short fluctuations in labour force potentially induced by the population corrections implemented by the Census Bureau in the census years.
The predicted cumulative curve is very sensitive to free term in (2). Even the initial difference of 0.0001 results in a tangible deviation from the measured curve after 50 years. Therefore, the value of free term in (2) can be estimated with a good accuracy. It is important that the cumulative curves represent actually measured macroeconomic variables: labour force and price. Inflation and change rate are based on first differences of the original values and thus are much more sensitive to measurement errors.
Figure 3. Comparison of the cumulative values of the observed and predicted inflation presented in Figure 2. The predicted curve starts from 1963 and is shifted by 2 years ahead. An agreement is observed with a notable change from convexity before 1980 to concavity one after 1980.
One can conclude that a deflationary period will likely start in 2012 and then may extend into the second half of the 2010s. Price deflation is a major risk for the stock market.
Deflation in Japan. The other view
Our previous post showed that inflation in Japan can be completely explained by the change in labor force. Obviously, there are different (and wrong) explanations based on monetary policy of the Bank of Japan. Below is an abstract of a working paper on this issue. In my view, it is absolutely worthless as not describing any period or major change in the inflation evolution. How can they seriously publish this kind nonsense?
Japan's Deflation and the Bank of Japan's Experience with Non-traditional Monetary Policy
This paper offers a brief summary of non-traditional monetary policy measures adopted by the Bank of Japan (BOJ) during the last two decades, especially the period between 1998-2006, when the so-called Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) were put in place. The paper begins with a typology of policies usable at low interest and inflation rates. They are: strategy (i), management of expectations about future policy rates; strategy (ii), targeted asset purchases; and strategy (iii), QE. Alternatively, QE may be decomposed into a pure attempt to inflate the central bank balance sheet, QE0, purchases of assets in dysfunctional markets, QE1 and purchases of assets to generate portfolio rebalancing, QE2. Strategy (ii), when non-sterilized, is either QE1 or QE2. Using this typology, I review the measures adopted by the BOJ and discuss evidence on the effectiveness of the measures. The broad conclusion is that strategies (i) and (ii) have affected interest rates, while no clear evidence exists so far of the effectiveness of strategy (iii), or QE0. Strategy (ii) has been effective especially in containing risk/liquidity premiums in dysfunctional money markets; that is, QE1 has been effective. The effectiveness of QE2, however, is unclear. The strategies, however, have failed to bring the economy out of the deflation trap so far. I discuss some possible reasons for this and also implications for the current U.S. situation.The GDP deflator in Japan
We have already mentioned that Japan is the best illustration of our concept linking inflation/unemployment to the change in labour force. In the previouspost on inflation in Japan, we modelled the overall CPI. Here we illustrate the long term equilibrium relation between the GDP deflator, DGDP, and labour force. All data were obtained from the OECD.
By trial-and-error, we seek for the best-fit coefficients in the linear and lagged link between inflation and labour force. Because of the structural (measurement related?) break in the 1980s, we have chosen the period after 1981 for linear regression, which is common for almost all economic studies related to Japan. By varying the lag and coefficients we have found the following relationship:
DGDP(t)= 1.9dLF(t-t0)/LF(t-t0) – 0.0084 (1)
where the time lag t0=0 years; Figure 1 depicts this best-fit case. There is no time lag between the inflation series and the labour force change series in Japan. Free term in (1), defining the level of price inflation in the absence of labour force change, is close to zero but negative.
A more precise and reliable representation of the observed and predicted inflation consists in the comparison of cumulative curves shown in the lower panel of Figure 1. We always stress that the cumulative values of price inflation and the change in labour force are the levels of price and labour force, respectively. Therefore, the summation of the annual reading gives the original estimates of price and workforce, which when are converted into rates.
Another advantage of the cumulative curves is that all short-term oscillations and uncorrelated noise in data as induced by inaccurate measurements and the inevitable bias in all definitions are effectively smoothed out. Any actual deviation between these two cumulative curves persists in time if measured values are not matched by the defining relationship. The predicted cumulative values are very sensitive to free term in (1).
For Japan, the DGDP cumulative curves are characterized by very complex and unusual for economics shapes. There was a period of intensive inflation growth and a long deflationary period. The labour force change, defining the predicted inflation curve, follows all the turns in the measured cumulative inflation with the coefficient of determination R2=0.96. (Again, these are actually measured curves.) With shrinking population, and thus, labour force, the GDP deflator will be falling through 2050 and likely beyond.
Figure 1. Measured GDP deflator and that predicted from the change rate of labour force. Upper panel: Annual curves smoothed with MA(3). Lower panel: Cumulative curves between 1981 and 2010. A good agreement between the cumulative curves illustrates the predictive power of our model.
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.
On the likelihood of deflation in Canada
Three years ago we published a paper on inflation and unemployment in Canada, where we presented a model linking inflation and unemployment with the change in labor force. This earlier prediction was revisited in 2010 and demonstrated excellent predictive power of the original model. Today we add two more readings, for 2008 and 2009, to all time series and extend the prediction.
Skipping the part introducing data and presenting individual models linking inflation and unemployment to labor force separately, we revisit our generalized relationship. It gathers all individual ones. We find the best-fit coefficients for the generalized equation:
pi(t) = 3.8dLF(t-2)/LF(t-2) + 0.79UE(t-2) - 0.095 (1)
Figure 1 depicts the case associated with the data provided by the BLS. Both cumulative curves are very close. Moreover, these curves reveal three periods of different behaviour and prove that there was no change in the long-term equilibrium relation between these three studied variables.
The difference between the cumulative curves is very small compared to the net change between 1969 and 2004. Moreover, this difference decreases with time as Figure 2 shows. One can easily find that the coefficients obtained by linear regression of the CPI on the LF and UE do not provide such a closeness between cumulative curves as those coefficients, which are estimated by visual fit between the cumulative curves.
Figure 1. Comparison of cumulative curve for the measured CPI and that predicted using the BLS definition of labour force.
Figure 2. The difference between the cumulative curves in Figure 1.
Figure 3 demonstrates the advantages of the moving average technique applied to the annual measurements of labour force, unemployment, and CPI inflation in Canada. As discussed above, these measurements are characterized by random errors, which are weighted through years in accordance with benchmark measurements. It means that the average measurement error approaches zero for the increasing length of time series. Therefore, a five-year moving average, MA(5), should significantly suppress random errors and provide close cumulative curves, as one can observe in Figure 1.
Figure 3. Comparison of MA(5) curve for the measured CPI and that predicted according to relationship (1).
Considering the accuracy of the CPI prediction between 1971 and 2009, one can expect the rate of consumer price inflation in Canada to fall very close zero on average during the next 5 years. It is very likely that few years will bring negative inflation rates, i.e. formal deflation.
