JACKSON HOLE, Wyo. - The U.S. economy is apt to experience further disinflation, though not outright deflation in coming quarters, according to an analysis presented to an array of Federal Reserve officials and other central bankers here Friday.
Harvard University Professor James Stock and Princeton University Professor Mark Watson anticipate at least a half percentage point further decline in the inflation rate by mid-2011 in a paper presented to the Kansas City Federal Reserve Bank's annual symposium.
They say an inflation upsurge, such as that which occurred in 2004, is possible, but suggest it is unlikely.
The findings would seem to play into the fears of many Fed officials who would like, if anything, to see a bit higher, not lower, inflation.
Based on the SPF (Survey of Professional Forecasters) forecasted path of unemployment, by the second quarter of 2011, the four-quarter rate of core PCE inflation is expected to drop another 0.5 percentage points from its second quarter 2010 value," write Stock and Watson.
The decline could be even greater, they contend.
Their new unemployment recession gap model forecasts a decline in the rate of four-quarter core PCE inflation of 0.8 percentage points from the second quarter of 2010 to the second quarter of 2011.
"The median forecast overall recession gap activity variables indicates a somewhat smaller decline, by 0.6 percentage points over this period," they add.
Stock and Watson are both research associates for the National Bureau of Economic Research. Stock serves on the Academic Advisory Board of the Federal Reserve Bank of Boston, while Watson has advised the Chicago Fed. They were among the presenters at a symposium on "Macroeconomic Challenges: The Decade Ahead," which includes Fed Chairman Ben Bernanke and most members of the Fed's policymaking Federal Open Market Committee.
The two professors stress "there is considerable uncertainty surrounding these point estimates of further declines in inflation."
For one thing, they write, "the volatility of trend inflation is currently at historically low levels." If volatility increases, the decline in could be "steeper."
What's more, they say, "inflation dynamics could change in the region in which conventional monetary policy becomes ineffective and the parametric model could be ill-equipped to handle this."
Also, Stock and Watson recall that in 2004 inflation spiked despite relatively high unemployment. But they attribute that primarily to a sharp rise in oil prices and depreciation of the dollar.
"Absent an explanation for the rise in inflation in 2004, we cannot rule out a similar fortuitous rise in the remaining quarters of the current episode, but neither can we offer a reason why it might happen again," they conclude.
So the most likely course is further disinflation in the opinion of Stock and Watson, which is just what Fed policymakers have been increasingly concerned about.
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