Inflation Expectations Matter for Federal Reserve’s Clout
(Bloomberg Opinion) -- After decades of rarely cracking 2%, inflation was up 5.3% year-over-year in August. This was unthinkable a few years ago, and it may get worse before it gets better. Ports, rails and trucks are backed up, and supply-chain shortages abound. Energy prices are creeping up, and it is not even winter yet.
Federal Reserve officials are trying to reassure the public that this is temporary, the natural result of taking an economy offline and restarting it, or that inflation is limited to a few quirky sectors like used cars. But at what stage does transitory inflation become permanent, and when do we need to worry? The answers are “not yet” and, more important, “now.”
All inflation pretty much starts as temporary. It could be due to a spike in oil prices, supply shortages that cause the prices of food and other goods to rise, or the injection of a lot of money into the economy by the Fed. But whether inflation peters out when conditions change depends on people’s expectations. If stores raise their prices because they expect shortages to last for a several months or a year and people demand higher wages to pay for the increase, inflation takes hold and is hard to extinguish. The role of expectations has received some pushback lately from senior Fed economist Jeremy Rudd. Expectations may not be a great predictor of sudden inflation, like the type we are seeing now. Economists also do not fully understand what drives expectations, and they are very difficult to observe. But there is good evidence that over the long term, expectations matter.
Expectations don’t just depend on how long shortages last; they are also influenced by policy. That is what went wrong in the 1970s. Prices of food and oil went up, and that was met with accommodative monetary policy. People expected inflation, and it became self-fulfilling. That’s in large part because the Fed also lacked credibility. The central bank was in a new, untested regime after the U.S. left the Bretton Woods system in 1971, and Fed Chair Arthur Burns was skeptical he could do much about prices. Inflation spiked from 1972 to 1974 and then rose again in 1976, rising to more than 13% by 1980. Finally, the Paul Volcker-led Fed increased rates enough to break inflation once and for all, but that led to a recession.
There are parallels today. The Fed in the 1970s also tried to reassure people that inflation would pass, as the central bank is doing now. And, despite a resurgence in inflation, the modern Fed is pursuing extremely accommodative policies, keeping interest rates near zero through 2022 and buying $120 billion worth of assets each month. The Fed is also promising to tolerate more inflation, even if it goes above target, though how much it will tolerate and for how long is unclear. The Fed may not have the credibility it once did. If Americans follow monetary history, they would expect higher inflation to take hold.
But some things are different, which may temper inflation expectations and help avoid a repeat of the 1970s. It is a more global economy; the U.S. now imports about 15% of its goods and services (nearly double the percentage in the early 70s) from other countries, many with cheaper labor, which means if global supply-chain issues are resolved, prices may fall, too. We also buy more goods online, which means prices are observable across many different sellers. This has become a deflationary force because pricing is more competitive and merchants (and buyers) know what others are charging and prices become more dynamic. Rudd argues labor is also less centralized. Unions traditionally negotiated cost-of-living increases in salaries. Only 6% of U.S. workers are unionized today, and wages are rarely pegged to inflation.
Inflation expectations may also be what economists call “well-anchored,” meaning people still don’t expect high inflation to stick around, even if they see some now. That could be because generations of Americans have never seen high inflation, and it can be hard to imagine risks you have never experienced. A survey from the New York Fed shows that a big generational divide has emerged over inflation expectations: Americans younger than 40 expect 3% inflation in the next three years; those older than 59 expect 4.9%.
The combination of better price information online and inflation naivete may keep expectations inflation from spiraling out of control.
But that doesn’t mean there won’t be costs and risks along the way. Wages are up; once companies pay people more, they can’t cut their wages, and high labor costs mean higher prices on all goods. Regular blips in the price of energy may also feature in the economy as the nation cuts production without reliable alternatives. That may lead to regular bouts of inflation. And in some ways the uncertainty can be just as economically damaging as regular high inflation because it alters expectations, too.
There is a good chance inflation will bounce around 3% or 4% in the coming years. This is not as catastrophic as the 1970s, but it is much larger than what people are used to, and it undermines any perception the Fed can manage its 2% target; increasing the target to match higher inflation won’t enhance its credibility. Without credibility, effective monetary policy is much harder because the Fed can’t influence expectations. And if it can’t do that, it can’t control inflation, either.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Allison Schrager is a Bloomberg Opinion columnist. She is a senior fellow at the Manhattan Institute and author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk."
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