St. Louis economists ask if the Great Moderation is over

Mercifully, CPI in the US has been on the decline, having peaked at over 9% YoY as recently as June.

Core CPI nearly touched 7% in September, which still boggles the mind.

Headline CPI for December came in at 6.5% YoY, in line with the expectations of most market analysts. 

This was the first sub-7% print since November 2021 and moderated from 7.1% last month.

Source: US BLS

Core CPI (non-food, non-energy) entered sub-6% territory for the first time since June 2022 and came in at 5.7% YoY.

Month on month, the CPI actually fell to -0.1%, while the core reading ticked higher to 0.3% from 0.2% in the previous release.

With the breach of the psychological 7% level, the market was nearly unanimous in its belief that the Fed will ease the magnitude of its rate hikes to the traditional 25 bps later this month.  

Five minutes before the release of the CPI, the CME’s FedWatch tool showed that the chances of a 25-bps hike in the next meeting stood at 77.3%.

Soon after the publication, this surged to 97.2%, although has now eased somewhat to about 91%.

Is the Great Moderation over?

Michael McCracken and Trần Khánh Ngân of the Federal Reserve Bank of St. Louis authored an interesting paper on the future of inflation.

An earlier piece on Invezz noted that in recent economic history, there were two instances of the CPI shooting above the 8% mark in the US.

In both cases, inflation refused to relent in a hurry,

In the seventies and eighties, US consumer price inflation breached 8% on two separate occasions. First, from 1973 to 1975, it stayed above 8% for 23 consecutive months. In the second case, between 1978 and 1982, this lasted a mammoth 41 consecutive months.

In contrast, although both headline and core CPI reached four-decade highs in 2022, such vicious inflation has been brought ‘under control’ at a much more rapid pace than during earlier instances.

To a large extent, the Fed’s flurry of super-sized rate hikes (an article on which can be read here) engineered a sharp pullback and has certainly shown some success in the near term.

But the big question is, that if dizzying levels of inflation can stay so high for so long, what will happen this time?

Will CPI keep falling to its long-term average rather rapidly, or are we in for very dark days of consistently high inflation?

Two realities

Recent US economic history can be split roughly into two halves.

The first is the post-Bretton Woods (and the end of the second world war) from 1945 to 1983. In this period, inflation was generally high and volatile.

Post 1983 or thereabout, inflation was much more subdued and limited.  

This period is known as ‘The Great Moderation’.

Of course, after the GFC, this difference was even starker.

Source: FRED Database

There are several reasons that this shift may have occurred in the 1980s.

A major contributor was likely the globalization of the workforce.

The pool of labour available to US enterprises suddenly increased manifold, with highly skilled workers from other countries entering the US market, often at a discount.

This drove wages down for American workers, and in turn, ushered in a fresh macroeconomic era where inflation became much more manageable.

In developed countries such as the US, worker compensation plays a big role in determining inflation trends.

The Federal Reserve notes that in this period,

…(the) shift that occurred from manufacturing to services would tend to reduce volatility…advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively… Deregulation of many industries may have contributed to the increasing flexibility of the economy and thereby allow the economy to adjust more smoothly to shocks of various kinds, thus leading to its greater stability.

The math

The authors investigated data from the Bureau of Labor Statistics (BLS) and the Bureau of Economic Analysis (BEA) to understand how inflationary dynamics have changed from before the onset of the Great Moderation to during it.

To do so, they calculated the autocorrelation among time series of four measures of inflation – CPI, core CPI, PCE and core PCE.

Simply put, they tested to see if there is a relationship between one of the inputs (say CPI), and a lagged version of itself, i.e., whether the inputs are impacted by their past values, and if so, by how much and for how long.

Source: Federal Reserve Bank of St Louis

The first graph traces the relationship between the four variables from 1960 to 1983, and their respective lagged values, for a period of 2 years.

All four measures are quite tightly packed and imply that they each are influenced by their lags by roughly comparable magnitudes over time.

In the beginning (that is to say, after a month or two), they each show a great dependence on the previously recorded values of inflation.

After a period of 24 months, the correlation with their respective lags is still quite strong, suggesting that the momentum of each indicator continued to persist and are highly influenced by their series history.

In such an environment, if inflation is high, it would tend to remain so for long durations.

Source: Federal Reserve Bank of St Louis

The series post-1983 shows a dramatically different picture.

Although the core measures continue to display a strong effect of lags even 24 months out, the headline (non-core) measures, show a sharp decline in their autocorrelation coefficients, suggesting that the effect of their respective series history has seen a marked dilution.

As a consequence, inflation, particularly headline, was much less likely to persist in the period after 1983, than before.

The authors note,

Though less obvious, this is also true for core measures: At the same horizon, autocorrelation coefficients for core CPI and PCE generally are a bit higher for the pre-Great Moderation period than they are during the Great Moderation.

Given the chaotic pathway of inflation over the past year or so, the authors argue that there exists a possibility that we may be switching away from the Great Moderation and into a pre-1980s environment, i.e., towards more persistent inflation.

If so, that would be very bad news for household portfolios and broader financial security.

What comes next?

One of the biggest differences between the 1980s and today is the sharp rise in protectionism.

Countries are increasingly looking inward or cultivating close-knit regional networks to fulfil their supply chain requirements and build a safety net.

A sharp fall in the globally available pool of labour is bound to be inflationary, especially in countries such as the US.

Much of this apprehension also flows from the vulnerability that comes from the global over-reliance on the dollar and the heavy price that the Asian Tigers had to pay during the crisis of 1997. 

In the near term, the pivot risk remains and geopolitical considerations continue to loom overhead.

With Fed credibility being paramount, any weakness in their narrative will drive inflationary pressures higher once again.

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