Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Useful Are Leading Indicators of Inflation?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Useful Are Leading Indicators of Inflation?

Article excerpt

Many economists expect inflation to rise in 1995. These expectations are based on various approaches to forecasting inflation. One approach is based on the standard economic theory that inflation rises when slack is eliminated from the economy and production exceeds capacity constraints. According to this view, measures of economic slack such as unemployment and capacity utilization provide useful information about the inflation outlook. But the relationship between slack and inflation is complicated and subject to variable lags.

Uncomfortable with this complex relationship, some analysts rely on alternative approaches to forecasting inflation. One approach is based on "leading indicators" of inflation. The leading indicators typically incorporate information on selected prices to augment or replace information on economic slack. The prices selected are usually key commodity prices that fluctuate more or less continuously in response to changing economic conditions. Prominent leading indicators of inflation include the price of gold, broader indexes of commodity prices, and composite indicators that combine several economic series believed to predict the inflation rate.

How useful are these leading indicators for forecasting inflation? This article examines five widely watched leading indicators. The first section evaluates the strengths and weaknesses of these indicators based on economic theory. The second section evaluates the leading indicators empirically, looking at how the indicators have performed by themselves and whether the indicators add useful information to a standard model relating inflation to economic slack. It is concluded that, of the five leading indicators, the composite indicators have given the most useful early warning signals of inflation turning points, but none of the indicators has recently been successful in predicting inflation magnitudes.

FIVE LEADING INDICATORS OF INFLATION

Five leading indicators of inflation are described in this section. The first is the price of gold, a commodity that once played an important role in the world monetary system and is still held as a store of value by investors in many countries. The next two indicators are the Commodity Research Bureau (CRB) index of commodity futures prices and the Journal of Commerce (JOC) index of industrial materials prices. These leading indicators are differing broad-based baskets of commodities that play a more important role than gold in current economic activity. The last two indicators are the Center for International Business Cycle Research (CIBCR) leading inflation index and the PaineWebber (PW) leading index. These indexes are composite leading indicators of inflation that combine broad-based commodity indexes with other economic variables believed to be useful in inflation forecasting.

The price of gold

The price of gold is viewed by some analysts as a leading indicator of inflation because gold is widely held as a store of value. Gold is a store of value partly because of its physical characteristics, such as durability and attractiveness, and partly because of its historical role as the centerpiece of the world monetary system (Laurent). Many countries issued gold coins and held stocks of gold bullion to fully or partially back their paper currencies. Thus, although gold has industrial uses, much of the demand for gold has always been as a store of value. Moreover, the supply of gold is relatively fixed because new gold production is small compared with the existing stock of the metal.

Even though gold no longer plays a key role in the world monetary system, the price of gold might be a good leading indicator of inflation. The rationale is that if enough people regard gold as a good store of value, the expectation of rising inflation could cause some investors to shift their funds out of financial assets with fixed nominal interest rates into gold coins or jewelry. Because the gold supply is relatively fixed, the price of gold might rise sharply with even a small increase in demand. …

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