Averting Inflation Crisis Turns on Something Fed Doesn’t Control
Federal Reserve Chairman Jerome Powell says controlling inflation expectations is key to achieving the central bank’s twin goals of price stability and maximum employment.
The trouble is that it is far from clear the Fed can do that as the economy emerges from the pandemic. Expectations among consumers can vary widely, depending on their age and gender -- and are not particularly sensitive to what the central bank does and says.
What’s more, the attitudes of businesses -- arguably the most important players in the inflation process because they set prices -- are a bit of a mystery because there are few surveys of their thinking on the subject.
“It certainly is difficult” to manage expectations, said former Fed Governor Randall Kroszner, who’s now a University of Chicago professor. “Especially when you don’t know exactly how to do it.”
Policy makers don’t want inflation fears to get out of control in part because of the danger that then leads to a self-fulfilling prophecy. Concerns about such a dynamic taking hold have been triggered by the acceleration in prices in recent months.
The shifts have seen Powell and his colleagues do a complete turnabout when it comes to trying to shape Americans’ inflation beliefs. At last August’s virtual Jackson Hole meeting, the Fed chief unveiled a new monetary framework aimed at preventing inflation expectations from falling too low, by deliberately seeking price rises above the Fed’s 2% target for a time.
Now, the central bank’s focus has shifted to trying to stop inflation concerns from spiraling after a 3.9% annual surge in prices in May and a jump in consumer expectations to their highest level since 2013 in a monthly New York Fed survey.
Powell argues that the steep price rises will prove to be largely transitory and that expectations on the whole are where the Fed wants them. Longer-term projections have risen to “a range that’s consistent with what our objectives are,” he told reporters on June 16 after policy makers unexpectedly penciled in two increases in interest rates in 2023 from their current setting near zero.
Some economists have played down the significance of shifts in expectations, arguing that there is little evidence since the 1980s that they’ve led to changes to behaviour and to actual inflation.
Kroszner, nevertheless, is worried.
“We have the biggest risk of inflation expectations becoming unanchored and moving up in the last couple of decades,” he said, while stressing that he doesn’t see a high probability of that happening.
The Fed’s attempt to fine-tune expectations is complicated by the different prisms through which consumers view price pressures.
“People who lived through high inflation have systematically higher inflation expectations, and a stronger dislike for inflation, than people who did not have this experience,” academic economists Olivier Coibion, Yuriy Gorodnichenko, Saten Kumar, and Mathieu Pedemonte wrote in a 2018 paper.
That showed through in the latest New York Fed survey. Consumers 60 years of age and older -- who lived through the inflationary 1970s -- had markedly higher expectations than those under 40, who’ve only known low and stable prices.
Women also tend to have higher inflation outlooks than men because they often do more of the shopping for groceries, the academic researchers said.
“For the typical U.S. household, their expectations are going to be very highly correlated with the price of gasoline, also the price of food,” Gorodnichenko, a University of California, Berkeley, professor, said in an interview. “People don’t pay attention to what the Fed is doing.”
Consumer inflation expectations also surged back in 2008, even amid the financial crisis the Fed was battling against, as oil prices climbed. Concerns then subsided as pump prices nosedived.
This time around, the jump in expectations may prove “stickier” because the booming post-pandemic economy makes another oil-price collapse unlikely, said Matthew Luzzetti, chief U.S. economist at Deutsche Bank AG.
Economists’ standard take is that if consumers think prices are headed significantly higher, they’ll buy goods and services today rather than waiting until tomorrow -- pushing prices up even further.
But Gorodnichenko argued that the process is much more complicated than that. “People associate inflation with a bad economy, so instead of spending more, they may cut their spending and withdraw,” he said.
There was certainly a flavor of that in the University of Michigan’s June survey of consumers. Buying attitudes for vehicles and homes fell to their lowest levels since 1982, while the number of respondents making spontaneous references to high prices for such purchases topped a November 1974 record.
Insight into how companies perceive the inflation outlook is even spottier, largely because surveys of their attitudes are sparse. The Fed’s new index of common inflation expectations -- a favorite of Vice Chairman Richard Clarida -- is comprised of 21 different measures, none of which directly covers firms.
One Atlanta Fed calculation does suggest that businesses -- like consumers -- see faster inflation ahead. Firms in that district, which includes Florida, Georgia and Alabama, expect their unit costs to rise 3% on average over the next 12 months, the most since the monthly survey began in 2011.
To be sure, the recent shift in the Fed’s focus has calmed inflation concerns, at least in financial markets.
Based on trading in Treasury securities, the five-year, five-year forward breakeven inflation rate -- one gage of longer-term investor expectations -- fell to 2.12% on June 18 from 2.3% on June 15 as the Fed meeting began, before it recovered to 2.18% on Wednesday.
Assessing the value of such measures isn’t straight-forward. In a 2016 speech, Janet Yellen, then the Fed chair and now Treasury secretary, highlighted gaps in economists’ knowledge about expectations, including how they are formed and how they’re influenced by monetary policy.
Unfortunately, policy makers’ grasp of the topic hasn’t advanced all that much since then.
“Even in normal, placid, steady times, the task of measuring inflation expectations is fraught and difficult,” said former Fed official David Wilcox, who is currently with the Peterson Institute for International Economics. “In times like now, that difficulty is magnified many times over.”
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