MNI INTERVIEW: US Inflation Could Take Many Years To Reach 2%

It will likely take U.S. inflation many more years than central bankers and financial markets expect to close in on 2% without a deep recession, though this slower path may be optimal for Federal Reserve officials pursuing a dual mandate, Cleveland Fed economists Randal Verbrugge and Saeed Zaman told MNI.

The FOMC projected in December that rates would rise to 5.1% this year, slowing the economy and reducing inflation to 2.1% by 2025, while the unemployment rate rises only modestly by about a percentage point. But new research by Verbrugge and Zaman show that combination to be implausible, based on historical relationships between unemployment and inflation. Their model forecasts an inflation rate of 2.7% in 2025, given a 4.6% unemployment rate, and it isn't until 2029 that inflation falls to 2.1%.

"We see inflation being higher for longer, essentially," Verbrugge told MNI's Fedspeak podcast.

"If you have neither a recessionary force pushing down inflation or an overheating force pushing up inflation, inflation just takes a long, long, long time to get back to its steady state of 2%. It's just very, very persistent -- much more persistent than most models recognize."

MILD RECESSIONARY FORCE

Cleveland Fed President Loretta Mester cited the pair's research in a speech last week, saying the findings "inform my view that the risks to inflation remain on the upside."

Verbrugge and Zaman's model is uniquely adapted to the current moment. To capture the relaxation of supply chain bottlenecks, it assumes a strong and rapid deceleration of goods prices through the end of 2023. On the housing side, the model incorporates CoreLogic's Single-Family Rent Index, shown to be a 12-month leading indicator of the rent component of CPI, in forecasting housing inflation for the first quarter of this year.

They then separately model the dynamics of each category with the unemployment gap. "With core goods, the relationship with unemployment is very weak," Zaman said. But housing costs and the remainder group of core price categories -- termed non-housing core services by Fed Chair Jerome Powell -- has "strong links with labor market movements."

The FOMC's projected rise in unemployment to 4.6% exerts a mild recessionary force in the pair's model, particularly on the housing component with some effect on non-housing services, pulling down inflation to 2.1% by 2029.

7.4% UNEMPLOYMENT RATE

If the FOMC becomes more optimistic about the prospect for job losses at the upcoming March meeting, as some analysts expect, then inflation "will be even higher for longer," Verbrugge said.

You wouldn't want to read too much into one inflation reading, he added, but the stronger-than-expected January CPI "happens to be consistent" with data showing a tighter labor market.

To achieve a 2.1% inflation rate by 2025, the model would require a much deeper recession with one year of 7.4% unemployment, the economists found. But a simple welfare analysis where deviations from 4% unemployment and 2% inflation are penalized would instead favor the December SEP outcome.

"We'd never find that the more severe recession is the more optimal path," Verbrugge said.