Academic journal article Business Economics

An Ordered Probit Approach to Predicting the Probability of Inflation/deflation

Academic journal article Business Economics

An Ordered Probit Approach to Predicting the Probability of Inflation/deflation

Article excerpt

This paper provides an ordered probit approach that estimates the probability six months in the future of three distinct scenarios for prices: inflation, deflation, or price stability. The traditional way of forecasting inflation is to predict a single level and/or growth rate of the PCE deflator. However, this approach is not useful for identifying options or risks facing decision-makers, especially in financial markets. Also, point estimates of inflation convey a sense of overconfidence. Our approach is more practical for decision-makers who must hedge their portfolios, but it is also useful for policymakers, investors, and consumers who must attach a probability with each possible scenario of future price trends. Our results indicate that since June 2011 the probability of deflation has been persistently higher than of the other two scenarios. Thus, the recent years' higher deflation probabilities may offer a justification for the persistence of the Federal Reserve's highly accommodative monetary policy during 2012-14. Business Economics (2015) 50, 12-19. doi: 10.1057/be.2015.1

Keywords: ordered probit, inflation, deflation, probability

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Today, the focus on monetary policy in United States, eurozone, and Japanese central banks is one of avoiding deflation. How likely is deflation? This paper provides an ordered probit approach that estimates the probability six months in the future of three distinct scenarios for prices: inflation, deflation, or price stability.

The traditional way of forecasting inflation is to predict a single level and/or growth rate of the personal consumption expenditure (PCE) deflator (or other measure of inflation). However, this approach suffers two problems. First, it is not useful for identifying the options and risks facing decision-makers, especially in financial markets, as trading/investment strategies are far more focused on the alternatives of inflation and deflation than if the inflation rate is 2.2 or 2.4 percent. Second, point estimates of inflation convey a sense of overconfidence. Our approach is more practical for decision-makers who must hedge their portfolios and is also useful for policymakers, investors, and consumers for attaching a probability to each scenario of future price trends: inflation, deflation, or stability.

Owing to the Great Recession (2007-09) and the simultaneous global financial meltdown, central banks reduced key interest rates dramatically while also significantly increasing central bank credit to private banks and markets. Meanwhile, fiscal policy in many governments injected trillions of dollars through stimulus packages. (1) Some analysts, because of the previously mentioned factors, worry about inflation. Alternatively, some analysts have argued that the private economy has changed, and this has created the possibility of deflation for three principal reasons. First, as a result of lower growth rates (GDP is less than its potential level for many developed countries), and therefore a large output gap, downward price pressures are to be expected. Second, higher unemployment rates along with huge jobs losses during the Great Recession have reduced wage pressures. Third, higher expected taxes--used to cover large government budget deficits in many countries with serious debt-management issues--have further led to expectations of restrictive fiscal policy and to uncertainty about the pace of future growth. In sum, a high level of uncertainty presently exists about the future path of prices toward inflation, deflation, or stability.

For decision-makers looking forward, it is important to estimate the probability of any of these three inflation scenarios. For instance, the Federal Open Market Committee (FOMC) sets the stance of the U.S. monetary policy, and inflation/deflation expectations play a key role in forming these monetary policy decisions. Thus, the FOMC typically raises the federal funds target rate (fed funds rate, hereafter) in case of inflationary expectations higher than their target rate and reduces it in case of deflationary expectations. …

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