In Which I Am Once Again Puzzled by Martin Feldstein: Monday Focus for October 6, 2014

I look at the track of the past twelve months’ core PCE chain-index inflation:

And I look at the annualized month-to-month changes:

And this is what I see: Over the past 50 months, only 11 have seen core inflation above 2%/year. Of the past 25 months, only 5 have seen core inflation above 2%/year. Of the past 12 months, only 2 have seen core inflation above 2%/year. Any reasonable time-series smoothing-and-forecasting algorithm tells us that PCE core inflation right now is about 1.4%/year.

Any reasonable estimate of the core-PCE inflation Phillips Curve tells us that to raise the inflation rate by 0.5%-points/year requires that the unemployment rate spend 2%-point-years below the NAIRU. Were the unemployment rate over the next four years to average 5.0% that would do it in expectation if the NAIRU were 5.5%. The Federal Reserve forecasts that if it remains on its current policy path that the average unemployment rate over the next four years will be 5.4%–enough to get us to 2.0%/year inflation in expectation by 2018 if the NAIRU is 5.9%, but not if it is any lower.

Thus I really do not understand what time-series analysis underlies Martin Feldstein with his claims not just that the Federal Reserve’s current monetary policy path is too loose but that the Federal Reserve will recognize that it is too loose and raise interest rates faster than the market or it currently expects over the next fifteen months:

Martin Feldstein: Why the Fed Will Go Faster: “The midpoint of the opinions recorded at most recent FOMC meeting…

…implies a federal funds rate of 1.25-1.5% at the end of 2015… by the end of 2016… less than 3%…. Inflation is already close to 2% or higher…. The Fed’s own analysis points to a long-term rate of about 4% when the long-term inflation rate is 2%. The… consumer price index was up 1.7% year-on-year… would have been even higher but for the anomalous decline in the most recent month. In the second quarter of this year, the annualized inflation rate was 4%…. PCE inflation at just 1.5% for the 12 months to August…. But PCE inflation has also been rising, with the most recent quarterly value at 2.3% year on year in the April-June period.
So if price stability were the Fed’s only goal, the federal funds rate should now be close to 4%….

The Fed is certainly correct that current labor-market conditions imply significant economic waste and personal hardship. But economists debate the extent to which these conditions reflect a cyclical demand shortfall or more structural problems…. Increases in demand that would cause a further reduction in the current unemployment rate would boost the inflation rate…. Alan Krueger… showed that the inflation rate reflects the level of short-term unemployment… rather than the overall unemployment rate…. With short-term unemployment currently at 4.2%, the inflation rate is indeed rising…. I would not be surprised by a continued rise in the inflation rate in 2015… [and] the Fed… rais[ing] the federal funds rate more rapidly and to a higher year-end level than its recent statements imply.

Three things have to be true about the world for Feldstein’s forecast of interest rates at the end of 2015 to be a good one:

1. The current underlying rate of core inflation has to be 2.0% rather than (as the Federal Reserve thinks) 1.5%.

2. The current NAIRU has to be north of 6.0% rather than (as the Federal Reserve thinks) south of 5.5%.

3. The current majority on the FOMC have to be sufficiently uncertain of their analysis that–even after six years of data that have broadly supported it rather than Feldstein’s analysis–they will turn on the dime of a year’s worth of data in which inflation slightly overshoots their expectations.

Now I would say that each of these is at most a one-third chance–which means that my assessment of Feldstein’s scenario is that it is a 0.04 chance. It could happen–weirder things have happened than interest rates by the end of 2015 significantly higher than the Federal Reserve’s current projected policy path. But…

I wonder if I can persuade Noah Smith to make another bet?