Evan Soltas
Sep 26, 2015

Up. But Not Up, Up, and Away.

For the last year, I've been putting together simple short-term forecasts for inflation using only oil prices. Since oil has been driving so much of the movement lately, the forecasts have been quite accurate. This January, before most of the decline in inflation, I said there was a 50-50 chance of deflation -- and, sure enough, PCE inflation hit just 0.2 percent in the summer.

What oil giveth, however, the year-over-year calculation taketh away.

Since inflation is usually examined on a year-over-year basis, there are often "base effects" -- if prices fall or rise sharply in one month, that shock is carried over for the next 11 months. And then, the next month, the effect vanishes as the shocked month drops off the base, sending inflation just as sharply in the opposite direction.

Here we go, then. Since much of the decline in oil prices happened in the summer and fall of 2014, inflation is likely to rise sharply in winter 2015. That's what you can see in the forecast above. My baseline forecast is that core and headline will be at or around 2 percent by January 2016.

The model is not really a forecasting model, because almost all its power comes from simple propagation of the oil price into inflation and then the capture of the base effect, so I would not take seriously any longer-term forecasts it produces. It's not designed, for example, to consider the effects of unemployment or wage growth on inflation, which are arguably more important to inflation in the medium run. It's just meant to give you some visibility six months or so ahead. There it succeeds.

So inflation will go up -- but not up, up, and away. The Fed's inflation target is a two-percent annual increase in prices, as measured by the PCE price index. It looks as though, once the oil shock dissipates, the inflation will be on target.

My only concern is what happens when everything snaps into place so quickly. In six months, with inflation at 2 percent and unemployment in the high 4 percent range, that might produce a substantial amount of pressure for the Fed to tighten quickly, even when the Fed should be responding to the signal in the inflation process, not oil-driven noise.

Update (10/13/15): I added +/- 1 standard error bars to the forecast generated by Monte Carlo simulation. I think a reasonable confidence that inflation will return to target is, at this point, warranted.