Consensus expectations were off regarding the November estimate for U.S. CPI inflation released yesterday. The 0.3% fall for headline inflation was a larger drop than estimated by 82 of the 84 economists who ventured forth with an opinion in Bloomberg’s survey. No-one offered up a forecast of a greater fall than 0.3%. We suspect that consensus expectations for inflation in early 2015 are similarly off the mark. Back-of-the-envelope calculations suggest that for a relatively wide range of oil price scenarios, over the next several months, the U.S. headline inflation rate will plunge.

A plunge for headline inflation is already baked in the cake for December. The E.I.A. surveys of gasoline prices at the pump December-to-date are down around 70 cents, year-on-year. That is almost double the 32 cent year-on-year fall registered in November. Based on the energy component alone, the CPI headline looks set up to fall around 0.7% for the month, which would take year-on-year headline inflation down to 0.3%. And it appears there is more to come. If we embed today’s energy futures prices into consumer product prices, the drop in first quarter 2015 CPI inflation could be breathtaking. For example, near-contract futures prices for gasoline are trading down $1.15, year-on-year.

Thus, we were puzzled when we read in the December Bloomberg survey that the mean expectation for CPI inflation for the year ended Q1:2015 is 1.4%. In stark contrast with the futures market, this forecast would seem to require some combination of a sharp rebound for oil prices and no echo effect of earlier declines on other consumer prices.

We did some simple calculations to see what different rebounds in the prices of crude oil and petroleum product prices might imply for the CPI. The result?

For a wide band of short-term oil price paths, the expectation for the CPI early next year that was reported in the survey is hard to fathom. Note that the calculations in the table depend exclusively on the direct effects that falling energy prices will have on the CPI. More specifically, these back-of-the-envelope computations assume that food prices continue to rise by 3%, year-on-year, and all other non-energy prices rise at a 2% pace. Even given these decidedly pro-inflation assumptions, we calculate that the headline CPI could be negative, year-on-year, in a world in which oil prices average $70/bbl. or less.

The Bloomberg survey also projects a core inflation rate of 1.7% to go with the 1.4% headline rate. Under the simple assumption that inflation excluding energy inflation is unchanged, we can extract an implicit oil price forecast from these core and headline forecasts. This suggests that the 1.4% headline CPI inflation for Q1:2015 is consistent with an oil price of around $87/bbl.

Is $87/bbl. a plausible price for Q1:2015? Of course. Given the volatility in the oil market at present, the price of oil could well end up in a wide variety of places. But remember we are talking about an average expected price. If we see some possibility that oil does not rebound so sharply, then to get the average of $87/bbl. we must see a similarly large chance of oil well above $87/bbl. This is not forecasting, it is arithmetic. History is not on the side of those predicting a sharp rebound in oil prices. In the period since 1984 there were three 6-month declines of 50% or more for oil prices. In all cases the market overshot and rebounded materially. In no case, however, was the lion’s share of the slide erased in short order.

And remember that the table above assumes no echo effects of lower energy prices on other goods. The $70/bbl. oil price in Q1:2015 would be down about 30% over the previous year. In such circumstances, is it reasonable to expect no echo effects in other prices? November’s CPI suggests no. Core goods prices, in November, fell by 0.4%, month-over-month. That is the biggest one month decline since 2006. Unless the entire fall in energy prices is reversed, echo effects are likely to be substantial.

What might this mean for monetary policy? First note that Fed policymakers prefer inflation as measured by the PCE deflator, but this measure is very likely to run below CPI inflation.^[1] Regardless of measure, most analysts agree that the Fed should strive to look through transitory changes in inflation due to dramatic changes in the price of individual components such as oil. The Fed has generally done so in the past, and has declared its intention to do so in the current instance. However, coming on the heels of 2 years of excessively low inflation, this could, over time, become an increasingly difficult stance to maintain, especially if the extended period of excessively low inflation starts to be reflected in longer-term expectations. For now the Fed is dismissing signs that this change in expectations may be starting. Chair Yellen explained in yesterday’s press conference:

But as the effects of these oil price declines and other transitory factors dissipate, and as resource utilization continues to rise, the Committee expects inflation to move gradually back toward its objective. In making this forecast, the Committee is mindful of the recent declines in market-based measures of inflation compensation. At this point, the Committee views these movements as likely to prove transitory, and survey-based measures of longer-term inflation expectations have remained stable. That said, developments in this area obviously bear close watching.

We have been arguing that there is a substantial chance that the Fed will in coming months be needing to focus its communication more heavily on how it views the weak inflation and on how policy might be used to deliver on the Fed’s strong commitment to the 2 percent inflation goal.

We continue to agree, however, with the FOMC’s modal scenario in which inflation begins to rise as transitory forces abate and resource slack continues to diminish. But it may be some time before that story is confirmed. Further, as we noted a few weeks back, a move back to 2% for inflation is likely to require a return to something above 3% for core services inflation—which has been stuck closer to 2 for several years. Waiting for evidence supporting the modal story is likely to require some patience, as the FOMC noted yesterday.

Footnotes:

1.For example, the CPI affords a weight of 23.8% to owners’ equivalent rent-the price one would pay were she to rent her house to herself. That constructed statistic continues to rise at a 2.7% annualized rate. The CPI, excluding OER, rose by only 1.2%, year-on-year in November. The PCE deflator’s weight for OER is only 11%. Thus a big inflation sub-index running at 2.7%, year-on-year will have less influence on the PCE deflator. [back]