Early this year, we expected a gradual pickup in core inflation as slack continued to decline. But today, a return to the target looks more elusive. The upward pressure from reduced slack now has to contend with downward pressure from a stronger dollar and lower commodity prices.
While these forces are likely to be roughly offsetting, we place somewhat greater confidence in the disinflationary pressures for two reasons.
First, it is difficult to be sure about how much slack remains. Second, the relationship between slack and price inflation is subject to substantial uncertainty. Indeed, mojor US cities with lower unemployment rate have only modestly higher core inflation on average, and many do not follow the expected pattern. In contrast, pass-through from a stronger dollar to cheaper import prices or from lower energy input costs to prices of airline fares, for example, is usually more mechnical.
These competing pressures are likely to appear in different categories of the core price indeces. Reduced slack should contribute upward pressure primarily to the prices of services, while a stronger dollar should contribute downward pressure primarily to the prices of goods such as apparel and new vehicles. We incorporate these findings in our bottom-up inflation model, which now projects flat to slightly lower core inflation over the next year.
Despite the recent decline in market measures of inflation expectations, we do not think that another year of 1.5% core inflation would constitute a substantial threat to the anchoring of long-term inflation expectations. But it would at the very least complicate Fed officials' intension to hike the funds rate sometime in mid-2015 or a bit later.
Moreover, the consequences of an average miss on either side of our forecast would probably be asymmetric. A quicker acceleration to the target would likely shift liftoff forward by at most one quarter from our September 2015 baseline, while a more substantial decline might delay liftoff by significantly more.
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