What is Keeping U.S. Core Inflation Low: Insights from a Bottom-Up Approach

39 Pages Posted: 9 Dec 2016

See all articles by Yasser Abdih

Yasser Abdih

International Monetary Fund (IMF)

Ravi Balakrishnan

International Monetary Fund (IMF) - Fiscal Affairs Department

Baoping Shang

International Monetary Fund (IMF) - Fiscal Affairs Department

Date Written: July 2016

Abstract

Over the past two decades, U.S. core PCE goods and services inflation have evolved differently. Against the backdrop of global concerns of low inflation, we use this trend as motivation to develop a bottom-up model of U.S. inflation. We find that domestic forces play a larger role relative to foreign factors in influencing core services inflation, while foreign factors predominantly drive core goods price changes. When comparing forecasting performance, we find that both the aggregate Phillips curve and the bottom up approach give low root mean square errors. The latter, however, is more informative in tracing the effects of shocks and understanding the exact channels through which they affect aggregate inflation. Using scenario analysis - and given a relatively low sensitivity of core inflation to changes in slack, both at the aggregate Phillips curve and sub-components levels - we find that global pressures will likely keep core PCE inflation below 2 percent for the foreseeable future unless the dollar starts to depreciate markedly and the unemployment rate goes well below the natural rate. These results support the accommodative stance of monetary policy pursued thus far and, going forward, underscore the need for proceeding cautiously and very gradually in raising the federal funds rate.

Keywords: Inflation, United States, Goods, Services, Health care, Monetary policy, Inflation measurement, Econometric models, Forecasting models, Inflation modeling and forecasting, Phillips curve, core goods and services inflation.

JEL Classification: C51, C52, C53, E31, E37

Suggested Citation

Abdih, Yasser and Balakrishnan, Ravi and Shang, Baoping, What is Keeping U.S. Core Inflation Low: Insights from a Bottom-Up Approach (July 2016). IMF Working Paper No. 16/124, Available at SSRN: https://ssrn.com/abstract=2882559

Yasser Abdih (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Ravi Balakrishnan

International Monetary Fund (IMF) - Fiscal Affairs Department ( email )

700 19th Street, NW
Washington, DC 20431
United States
001 202 623 5674 (Phone)
001 202 623 6249 (Fax)

Baoping Shang

International Monetary Fund (IMF) - Fiscal Affairs Department ( email )

700 19th Street, NW
Washington, DC 20431
United States

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