By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – The U.S. economy is apt to experience
further disinflation, though not outright deflation in coming quarters,
according to an analysis presented to an array of Federal Reserve
officials and other central bankers here Friday.

Harvard University Professor James Stock and Princeton University
Professor Mark Watson anticipate at least a half percentage point
further decline in the inflation rate by mid-2011 in a paper presented
to the Kansas City Federal Reserve Bank’s annual symposium.

They say an inflation upsurge, such as that which occurred in 2004,
is possible, but suggest it is unlikely.

The findings would seem to play into the fears of many Fed
officials who would like, if anything, to see a bit higher, not lower,
inflation.

Based on the SPF (Survey of Professional Forecasters) forecasted
path of unemployment, by the second quarter of 2011, the four-quarter
rate of core PCE inflation is expected to drop another 0.5 percentage
points from its second quarter 2010 value,” write Stock and Watson.

The decline could be even greater, they contend.

Their new unemployment recession gap model forecasts a decline in
the rate of four-quarter core PCE inflation of 0.8 percentage points
from the second quarter of 2010 to the second quarter of 2011.

“The median forecast overall recession gap activity variables
indicates a somewhat smaller decline, by 0.6 percentage points over this
period,” they add.

Stock and Watson are both research associates for the National
Bureau of Economic Research. Stock serves on the Academic Advisory Board
of the Federal Reserve Bank of Boston, while Watson has advised the
Chicago Fed. They were among the presenters at a symposium on
“Macroeconomic Challenges: The Decade Ahead,” which includes Fed
Chairman Ben Bernanke and most members of the Fed’s policymaking Federal
Open Market Committee.

The two professors stress “there is considerable uncertainty
surrounding these point estimates of further declines in inflation.”

For one thing, they write, “the volatility of trend inflation is
currently at historically low levels.” If volatility increases, the
decline in could be “steeper.”

What’s more, they say, “inflation dynamics could change in the
region in which conventional monetary policy becomes ineffective and the
parametric model could be ill-equipped to handle this.”

Also, Stock and Watson recall that in 2004 inflation spiked despite
relatively high unemployment. But they attribute that primarily to a
sharp rise in oil prices and depreciation of the dollar.

“Absent an explanation for the rise in inflation in 2004, we cannot
rule out a similar fortuitous rise in the remaining quarters of the
current episode, but neither can we offer a reason why it might happen
again,” they conclude.

So the most likely course is further disinflation in the opinion of
Stock and Watson, which is just what Fed policymakers have been
increasingly concerned about.

** Market News International **

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