Every week, millions of Canadians anxiously await the Bank of Canada’s latest pronouncement on interest rates. A shift of a single percentage point up or down can mean hundreds or even thousands of dollars lost or saved on a mortgage, car loan or business investment.
But predicting interest rates is difficult. Much depends on inflation, which central bankers try to reduce by raising interest rates. Now, they have found a new and increasingly fashionable tool to forecast long-term inflation trends—an algebraic equation. If proved successful, the method could make it possible for governments to forecast long-term inflation rates and, in turn, to help make interest rates more predictable.
The new formula, called “P-Star” (P*), is a fresh look at well-established monetarist theories that chart the relationship between money supply and price levels. The equation provides a long-term view of inflation. If P* suggests that inflation will remain steady over one or two years, central bankers could avoid raising interest rates when other economic indicators—such as the monthly consumer price index—suggest that inflation could be rising. The U.S. Federal Reserve Board lowered interest rates earlier this month, despite signs of increasing inflation. According to some analysts, that was partly because the P* equation indicates that inflation should not increase above current levels for about two years.
So far, the model has not been applied in Canada, but Donald Stephenson, chief of the international department at the Bank of Canada, said last week that Canadian officials have informally discussed the theory with the economists at the reserve board. Said Stephenson: “If the theory holds, it could give us another guide to inflation—but Canada hasn’t looked at it thoroughly yet.”
The P* equation departs from past theories by using a stable value for so-called velocity, the number of times that money changes hands as it flows through the financial system. As it moves through a series of transactions, the stock of money is used and reused to finance output—total goods and services. Typically,
the value of that output increases more than the value of the money used to support it. To avoid surges in output that could lead to inflation, central bankers try to limit the money supply. But they have no way of controlling the number of transactions, or velocity, of money after it has entered the system. And if the output increases too quickly, inflation can result.
By calculating the longterm velocity factor from studies of the past 33 years, officials at the reserve board say that P* may prove a valuable new tool to help predict whether inflation will rise or fall in the future. The reserve board economists discovered that, despite temporary fluctuations, the velocity rate over the past 33 years was 1.6527—that every $100 that the Fed injected into the economy became $165.27 during the course of the year.
By assuming that the average rate of increase remains the same in the future, the researchers were able to write an equation that helps forecast future price levels. And by comparing
current price levels with P*, which stands for future expected prices, economists can predict whether prices are likely to move up or down.
Federal Reserve Board chairman Alan Greenspan unveiled P* last February when he used it to support submissions on monetary policy to the House and Senate banking committees. Some U.S. financial experts say that Greenspan’s reliance on the P* equation during that testimony is evidence of the board’s faith in the discovery. Greenspan himself commissioned the research that led to the development of the equation. The study, worked on by reserve board economists Richard Porter, Jeffrey Hallman and David Small last year, was known as the “Holy Grail study” among reserve board staff.
Hallman warned that the equation should not be viewed as a revolutionary tool that will make inflation forecasts foolproof. Its main usefulness, he said, is its simplicity. In the past, central bankers have had to rely on a confusing array of indicators that are in constant flux, ineluding exchange rates, budget deficits and interest rates. P* now provides a method of “forecasting inflation over the mediumto long-term without much information,” Hallman said.
necessary And even the equation’s own creators have cautioned against placing too much reliance on their discovery. Porter noted that as yet the Fed has no stated policy on the use of the equation and that it remains one tool among many others for making economic projections. He also said that there is no guarantee that the constancy of the velocity figure will endure in the future. And some economists in Canada questioned the equation’s usefulness. Said Douglas Peters, chief economist for the Toronto-Dominion Bank: “I guess it is an interesting thing to look at but it is not a great new tool. I am highly skeptical.” But in the guessing game that inflation and interest rates have become—for both consumers 3 and the business communijc. ty—any new signposts to the < future are welcome. The P* ° equation may be one of those convert signposts and, until it is proven wrong, it is likely that many financial market-watchers will look to P* for hints of things to come.
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