Evan Soltas
Oct 12, 2014

Disinflation, Here We Come

Update (10/14)

It seemed worth bringing this question to the data. I built a simple three-variable vector autoregression of monthly PCE headline and core inflation and the monthly change in the Brent crude spot.

Assuming a price of $84/barrel -- yesterday's close -- I get that headline PCE inflation should bottom out at 0.9 percent in June 2015, incorporating in base effects. So the back-of-the-envelope calculations below check out nicely. We'll see if the model's forecasts hold up.

For future reference, the rule of thumb that comes out of the impulse response function is that for every 10-percentage-point increase in the spot price of Brent crude, expect 0.8 percentage points more in annualized headline PCE inflation for the next four months.

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Spot prices for oil have dropped 20 percent in the last three months, from $110 to $90 a barrel. If they remain at these levels, inflation in the United States will slow quite a bit, and quickly at that. My estimate is that headline PCE inflation will fall to just under 1 percent within the next three months of data.

The estimate isn't that difficult to reach. Gas prices track closely with Brent crude, and some of the drop has already filtered into average prices at the pump, and some of that might already be in the August PCE data -- it's not clear exactly how much.

Suppose gasoline, as counted in PCE, end up 10 percent cheaper in September than in August. And energy goods and services is about 5 percent of personal consumption, of which 3 percentage points of that is directly gasoline. The other energy prices moves in tandem, and there are plenty of other prices in the economy that are sensitive to gasoline -- so that gives you about a half percentage-point drop in PCE inflation.

Recall that PCE inflation is 1.5 percent year-over-year. So, one surprise from energy markets, and we could be below one percent. At a time when we are supposed to be a couple months away from a rate hike, this could complicate the exit plan.