What do price equations say about future inflation?

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Author: Ray C. Fair
Date: July 2021
From: Business Economics(Vol. 56, Issue 3)
Publisher: Springer
Document Type: Article
Length: 7,630 words
Lexile Measure: 1310L

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This paper uses an econometric approach to examine the inflation consequences of the American Rescue Plan Act of 2021. Price equations are estimated and used to forecast future inflation. The main results are: (1) The data suggest that price equations should be specified in level form rather than in first or second difference form. (2) There is some slight evidence of nonlinear demand effects on prices. (3) There is no evidence that demand effects have gotten smaller over time. 4) The stimulus from the act combined with large wealth effects from past household saving, rising stock prices, and rising housing prices is large and is forecast to drive the unemployment rate down to below 3.5 percent by the middle of 2022. 5) Given this stimulus, the inflation rate is forecast to rise to slightly under 5 percent by the middle of 2022 and then comes down slowly. 6) There is considerable uncertainty in the point forecasts, especially two years out. The probability that inflation will be larger than 6 percent next year is estimated to be 31.6 percent. 7) If the Fed were behaving as historically estimated, it would raise the interest rate to about 3 percent by the end of 2021 and 3.5 percent by the end of 2022 according to the forecast. This would lower inflation, although slowly. By the middle of 2022 inflation would be about 1 percentage point lower. The unemployment rate would be 0.5 percentage points higher.

Keywords Price equations * Inflation * Fed policy

1 Introduction

The passage of the American Rescue Plan Act in March 2021 has led to much debate about its future inflation consequences. Larry Summers (2021), among others, has argued that the inflation consequences could be severe. The Biden administration and the Fed have argued there is likely to be a blip in inflation in 2021 but nothing long-lasting. Most of this discussion is based on casual empiricism rather than econometric estimates. This paper takes an econometric approach and examines what estimated price equations imply about future inflation. As of this writing data are available for the first quarter of 2021, so the forecast period begins with the second quarter of 2021. It ends in the fourth quarter of 2023.

The price and wage equations in my U.S. macroeconometric model (the US model) are used as a base, but a number of price equations are examined. In previous work (1) I have argued that the data do not support the dynamics of the expectations-augmented Phillips curve, and this issue is examined further in this paper. The dynamics of price equations are crucial for examining long-run inflation consequences from a short-run blip. For example, are the Administration and the Fed right in their view that there are no long run consequences? It will be seen that the data support the specification of price equations in level form rather than in first difference or second difference form. The NAIRU specification does not appear to be supported by the data.

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Gale Document Number: GALE|A673455233