As expected under current conditions, there is strong disagreement among the forecasters, or say it in another way, there is a wide dispersion of opinions on the future path of inflation. The disagreement is particularly sensitive to the time horizon of the forecast. If the forecast time horizon is one year or a little bit more, there is a strong group within the forecasters that tilts the average forecast much lower (0.25% vs. the median 2%) and increases the dispersion of opinions or the disagreement. This group predicts much lower inflation than the average to occur and more deflation of the economy to realize in a year period. This group is influenced by the rising unemployment rate and the high excess capacity in the overall economy.

For the five- and ten-year time forecast horizons, there is also a group of forecasters that tilts the average forecast up significantly (4% vs. the median 2.75%), thus increasing the disagreement. This group is concerned that the Fed will politically be forced to monetize the enormous federal deficit (buy large quantities of Treasury securities), and accommodate the pace of higher inflation. Future federal deficits are expected to increase the federal debt to more than $12 trillion dollars in the next few years. This group is thus concerned that the Fed will not be able to appropriately remove its extraordinary monetary stimulus when the economy recovers. This concern may be far-fetched because there is no empirical evidence that links large public debt with high inflation. Japan in the late 1980s is an example.

The huge dispersion of opinions or disagreement among the forecasters increases uncertainty and complicates decision-making. The Fed in particular will find it difficult to communicate this policy to other decision-makers in the economy. The Fed has a message to convey to all those decisions-makers that it has a vision and it stands ready to use all its tools to prevent  drops in price to turn into actual deflation in the next year and to ensure price stability in the medium to long run. An increase in the disagreement about future inflation in the short, medium and long runs will make the Fed’s communication strategy difficult.

One reason for the first group (41% of the forecasters) to forecast much lower inflation rate in the next year or so is that it uses the unemployment gap (difference between the actual unemployment and the natural unemployment or NAIRU (4.8% now)) as part of its forecasting tool, the Philips curve. This gap is now substantial (9.8% - 4.8% = 5%) and exerts a heavy weight on the future inflation rate. Even if we use the predicted 9.5% unemployment rate for 2010 and 9% for 2011, the gap will still be enormous!

Understanding the reasons for the disagreement and dispersion of opinions about near and long term inflations should help the Fed communicate its strategy and goals better to all interested constituents in the economy. Greater disagreement could mean an increase in interest rate risk premiums or the extra compensation investors demand for additional risk.The constituents should pay special attention to better predictions of the unemployment rate for the next year or so and to the size of federal deficits in the coming years. For the Fed, these forecasts show that there is a high possibility of tradeoff between the short run and the long run inflations. If it tries to alleviate deflation or disinflation in the short run, it can stock fears of high inflation in the long run. If these concerns are taken into account during deliberations, the Fed should be able to navigate its inflation policy better over time.

[1] Paul Krugman, the 2008 Noble Prize Laureate in Economics, disagrees. He believes that the monetary base which includes the bank excess reserves at the Fed will not lead to inflation because the economy is in a liquidity trap. He cited Japan during the lost decade and the Great Depression as examples. See http://krugman.blogs.nytimes.com/2009/06/13/way-off-base/

[2] Federal Reserve Bank of San Francisco (October 5th), "Disagreement about Future Inflation," Economic Letter, http://www.frbsf.org/publications/economics/letter/2009/el2009-31.html