Managing "Inflation" Expectations

Two recent items in the news make a whole lot more sense when looked at together rather than separately. The first item is Federal Reserve Chairman Ben Bernanke's speech from about a week ago at Princeton on The Benefits of Price Stability. The other is a Welling@Weeden interview (PDF) with John Williams of Shadow Government Statistics notoriety.

The connection between the two should be immediately clear to readers here - it is the details that carry the intrigue, as you'll soon see.

While the economic and monetary policy history described in the new Fed Chair's speech is quite interesting and demonstrative of his academic background and the zeal with which he approaches his current job, it is the discussion of "inflation" expectations that is deserving of scrutiny today.

The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable.

If people believe that "inflation" is low and that it will remain so, interest rates can also be kept low providing stimulus for both economic growth and employment.

This mechanism can be illustrated by comparing the effects of the recent rise in oil prices to the effects of the oil price increases of the 1970s. Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. The Fed, attempting to gain control of the deteriorating inflation situation, raised interest rates sharply; however, initially at least, these increases proved insufficient to control inflation or inflation expectations, and they added substantially to the volatility of output and employment. The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.

Setting aside the very significant effect of globalization on both the prices of consumer goods and domestic wages, it seems that the other key to low "inflation" over the longer term is the setting of expectations for the future based on current conditions.

That is, regardless of the reality that individuals may experience in their daily lives today, if the perception is maintained that "inflation" is currently low, "inflation" expectations for the future will also be low. Under these conditions, interest rates can remain accommodative and economic growth and job creation will result.

Apparently, had "inflation" been managed better back in the 1970s, maybe there wouldn't have been such a fuss over rising prices and Paul Volcker wouldn't have had to raise interest rates to 20 percent.

How do you manage "inflation"?

We'll get to John Williams shortly, but the "core" issue with managing "inflation" today is all about excluding things that are going up in price.

By contrast, the oil price increases of recent years appear to have had only a limited effect on core inflation (that is, inflation in the prices of goods other than energy and food), nor do they appear to have generated significant macroeconomic volatility... But, the crucial difference from the 1970s, in my view, is that today inflation expectations are low and stable (as shown, for example, by many surveys and a variety of financial indicators). Oil price increases in the past few years, unlike in the 1970s, have not fed through to any great extent into longer-term inflation expectations and core inflation, as the public has shown confidence that any increases in inflation will be temporary and that, in the long run, inflation will remain low. As a result, the Fed has not had to raise interest rates sharply as it did in the 1970s but instead has been able to pursue a policy that is more gradual and predictable.

It remains to be seen how long the public will view increases in "inflation" as temporary, but again, the point here is that, irrespective of other factors, given low current "inflation", it is easier to maintain low "inflation" expectations, which allows interest rates to remain relatively low.

Readers may at this point be wondering why the word "inflation" has been in quotes everywhere it has appeared outside of the text of Mr. Bernanke's speech. The short answer is that the quotes indicate ambiguity or uncertainty, something that is readily admitted when it comes to using this word in today's musing.

Others either see no ambiguity or perhaps view the ambiguity as something that can be used to their advantage. It may interest you to know that in the three excerpts provided thus far from the Princeton speech, the word "inflation" has appeared 18 times, the word "low" has appeared six times, and the word "core" two times.

Repetition, selective qualifiers, and, of course, statistical wizardry are also keys to low "inflation" and the management thereof, which, naturally brings us to John Williams.

Much of this interview deals with federal budgets and related topics, but the history of the consumer price index and its attendant data collection and reporting should shed new light on just how "inflation" has been managed since the 1970s. Presumably, a different sort of management than what Mr. Bernanke was referring to in his speech.

There was a very deliberate effort in the early 1990s under the auspices of Michael Boskin, who at the time was the head of the Council of Economic Advisors, in conjunction with Alan Greenspan, who, of course, was Fed Chairman, to “fix” the CPI. The story, very simply, was that CPI was supposedly overstating inflation. The pitch was that if people go out to shop and find that buying a steak is getting expensive, they buy hamburger instead... The problem is that if you allow substitutions, you aren’t measuring a constant standard of living. You’re measuring the cost of survival. You can keep substituting down and have people buy dog food instead of hamburger. It happens. But that’s not the original concept behind the CPI.

Of course the owner's equivalent rent substituted for homeownership costs as well as understating rising health care costs also go a long way in making "inflation" appear as something increasingly different from what people actually experience in their lives.

Lately, with rising energy prices, the emphasis has been on the two-percent rate of core "inflation", rather than the much higher all-items rate of "inflation" currently in the four percent range.

All in all, if you were to peel back changes that were made in the CPI going back to the Carter years, you’d see that the CPI would now be 3.5%-4% higher. The difference that it makes is significant: if the same CPI were used today as was used when Jimmy Carter was President, Social Security checks would be 70% higher.

That would put the all-items CPI close to eight percent which would undoubtedly capture much more of the public's attention. A side effect of reverting to the old calculation would make real GDP much different than official reports - the just released sub-two percent GDP figure for December would swing far into negative territory.

Higher "inflation" numbers can cause all kinds of problems.

Maybe the management of "inflation" has more to do with the work of the statisticians at the Bureau of Labor Statistics than it does with Federal Reserve policy, or maybe they are really one in the same.