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March 16, 1984
Comparing Inflation Forecasts
rawly defined money, or M1, expanded by
1 3.4 percent from july 1982 to July 1983
-the highest sustained monetary expan.sion
since World War II. The growth of M 1 has
since slowed, but in the past inflation has
tended to follow the path of M 1 growth with
an average lag of 2 to 3 years. The high
money growth of 1982 and 1983 in this view
ordinarily would raise inflation in 1984.
Inflation forecasts for 1984 appear to be
subject to more than the usual uncertainty.
To a large extent, the differences in these
forecasts reflect different theoretical
approaches to explaining inflation. In one
view, the effects of the rapid monetary
growth that occurred during 1982 and 1983
dominate. An alternative view stressesthe
influence of higher than normal economic
slack. According to the latter view, high
monetary growth cannot boost the inflation
rate unless it puts pressure on wages
and prices by reducing the rate of·
unemployment.
This approach is not necessarily incompatible with the first since the dynamics
of the inflationary process are likely to be
as depicted in the slack model. Fastermonetary growth should first produce increases
in real aggregate demand that reduce economic slack; but as inflationaccelerates
because of this reduction in slack, real
money balances fall. The resulting reduction
in real aggregate demand would then return
the level of economic slack to its trend. The
only long-run effect of higher monetary
growth would be on inflation, but the
mechanism of transmission would be
temporary movements in slack.
This Letter describes these two models and
compares their forecasts for 1984. We show
that while the two approaches normally
forecast inflation equally well, the model
emphasi Zing the effects of economic slack is
I ikely to provide a better forecast of inflation
over the next year or two.
Two views
The approach to modeling inflation
embodied in most large structural econometric models focuses on the effects of
economic slack-particularly slack in the
market for labor -and of expectations of
future inflation. What labor market participants presumably really care about are
anticipated real wages. Thus, money wages
adjust by increasing faster relative to anticipatedinflation when labor markets are tight
than when they are loose, even though the
aggregate level of money wages does not
movequickly enough to clear the market for
labor in any particular year. Since prices are
viewed as being primarily determined by a
mark-up over unit labor costs, the implication of these models is that realized inflation
tends to be higher when labor markets are
tight. When labor markets are neither particularly tight nor loose, the inflation rate tends
to be equal to that anticipated.
If past movements in monetary growth are
the dominant determinant of short-run
movements in economic slack, as monetarists believe, the monetary approach has
an important advantage for forecasting. A
forecast of inflation based upon past monetary growth would implicitly embody
about as good a forecast of economic slack
as can be made.
Formal models
We have used econometric equations
embodying these two approaches to compare their forecasts of inflation. The equations were estimated over the period from
1964 through 1980. To make a clean test of
their comparative forecasting powers, the
temporary effects of supply shocks unrelated
to current demand conditions were removed. This was done by using the implicit
price deflator for personal consumption
The other view argues that inflation is
basically a monetary phenomenon. Nar1
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Forecasts for 1 984
Beyond the period of estimation, the
accuracy of these two approaches to forecasting inflation is very different. The
economic slack model tracks the decline in
the inflation rate during 1982 and 1983
quite well, with an average absolute error of
only 0.<,)of a percentage point. In making
these forecasts, the slack model's past
predictions of inflation were used in the
measure of expected inflation, so that the
forecasts depend only upon movements in
slack. In contrast, the monetary model overpredicts inflation quite badly in 1 982, with
an average absolute error of 1.7 percentage
points. Theerrorin 1983 isevenworseat4.0
percentage points. For 1984, the two forecasts continue to diverge, with the monetary
model forecasting a 9.2 percent inflation
rate from fourth quarterto fourth quarter and
the slack model predicting 6.3 percent.
expenditures, excluding food and energy,
for the measure of prices. In principle,
movements in the real exchange value of the
dollar could affect consumer prices in a way
similar to supply shocks. But statistical tests
indicated that this effect was not important
in the period of estimation.
The economic slack model of inflation contains measures of slack and expected inflation. The central tendency of inflation is the
rate of inflation anticipated. Variations in
inflation around this central tendency are
captured by movements in the slack variable. For the slack, the current unemployment rate for males in the 25-54 age bracket
was used. The normal, or non-cyclical, rate
of unemployment in this measure has been
less affected by demographic shifts over
time, making it preferable to the total unemployment rate. Expected inflation is measured by past changes in the price index over
the previous 16 quarters.
For the monetary equation, M 1 growth of 6
percent, equal to the mid-point of the Federal Reserve's current target range, was
assumed for 1 984. The forecast from the
slack model is based on the 0.8 of a percentage point reduction in the national
unemployment rate for 1 984 predicted by
a sample of forecasters polled by the American Statistical Association and the National
Bureau of Economic Research, and on the
historical relationship between changes in
the unemployment rates for the total labor
force and males of prime age. Interestingly,
this sample of forecasters predicts a 5.4
percent inflation rate for 1 984 (measured by
the G N P deflator)-much
closer to the forecast of the slack model than that of the
monetary model.
The monetary model of inflation simply
contains current and past monetary growth.
It is thus a"reduced-form" relationship that
leaves the transmission mechanism relating
money to prices implicit in the lag structure.
Current and lagged changes in M 1 growth
over 16 quarters were used.
Within the period of estimation (a portion of
which is:shown in the chart), the tWb approaches predictthe inflation rate equally
well. The average difference between the
actual annualized inflation rate in anyone
quarter and the predicted value is 0.7 of a
percentage point in each case. Also, to the
extent that economic slack affects inflation,
its influence appears to have already been
captured by past monetary growth within
the sample period. This is indicated by the
fact that when the unemployment rate is
included in the monetarist equation, which
contains current and past monetary growth,
there is no significant reduction in the
prediction error.
The slack model is likely to provide a better
inflation forecast for 1 984 than the monetary
model because it was more accu rate in 1982
and 1 983 and because it produces an inflation forecast closer to the current consensus.
Although the monetary model normally has
the advantage of not requiring an indepen-
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Inflation Forecasts
Deflator for Personal
Consumption Expenditures·
12
10
8
6
4
2
Period
Forecast Period
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1978
1979
..
term positive growth trend of 3 percent. As a
result, economic slack is now higher than
cou Id have been predicted on the basis of
prior monetary growth. Moreover, most
forecasts for 1984 indicate gradual reductions in slack that would not usually be
enough to generate significant increases in
inflation.
Adrian W. Throop
dent forecast of economic slack, forecastsof
slack based purely on monetary considerations have not fared well recently due to
declines in the income velocity of money, or
its rates of turnover. Between the fourth
quarter of 1981 and and the first quarter of
1 983, the velocity of M1 dropped at a 5.5percent annual rate, compared to a long-
Estimation
.....
1980
1981
1982
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1983
1984
*(Annualized Percent Change; Food and Energy Excluded)
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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
( Dollar amounts in millions)
Selected Assetsand Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted)
Other Transaction Balances4
Total Non-Transaction Balarices6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Weekly Averages
of Daily Figures
ReservePosition, All Reporting Banks
Excess Reserves ( +)/Deficiency (- )
Borrowings
Net free reserves (+ )/Net borrowed( -)
1
Amount
Outstanding
2/29/84
Change
from
2/22/84
177,701
157,394
46,262
59,229
26,950
5,006
12,187
8,119
185,994
44,236
28,698
12,004
129,752
2,209
2,267
449
66
125
3
37
- 20
2,020
1,824
1,225
73
122
40,373
94
38,085
20,222
Weekended
2/29/84
-
-
Change from
year ago
Dollar
Percent
-
-
-
-
1,676
2,039
299
330
299
56
319
44
5,002
5,000
2,633
770
768
-
-
776
-
11
716
79
2,784
Weekended
2/22/84
NA
NA
NA
-
NA
NA
NA
4.8
6.6
3.3
2.8
5.6
5.6
12.8
2.7
13.1
50.8
42.0
30.1
3.0
9.8
-
1.0
60.5
Comparable
year-ago period
NA
NA
NA
Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
u.s.
) Excludes
government and depository institution deposits and cash items
4 ATS, N OW, Super N OW and savings accountswith telephone transfers
s Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
Editorial commentsmay be addressedto the editor (GregoryTong)or to the author .... Freecopiesof
Federal Reservepublications can be obtained from the Public Information Section, FederalReserve
Bank of San Francisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 974-2246.
@FedFRASER