The Relevance of Inflation Expectations

There's been a lot of wonk-talk lately about inflation expectations and their relevance to monetary policy - a real cat-fight amongst the dismal scientists.

It all started with the paper Understanding the Inflation Process(.pdf), presented at last week's U.S. Monetary Policy Forum 2007. Among other less notable items, the report stated that measures of "inflation expectations", an indicator long favored by policymakers at the Federal Reserve, have not provided "useful forecasts of the estimated trend in U.S. core CPI inflation" over the last twenty years.

Before getting on with the obligatory excerpt from some speech by a Federal Reserve board member, let's have a look at the relationship between current gasoline prices and expectations of future inflation.

As shown below, aside from some understandable overshoot, there is a high correlation between prices at the pump and the answer to the survey question, "How much do you think prices will rise in the next year?"


It makes sense when you think about it. Amid confusing pricing for groceries and medical expenses, most people are understandably perplexed when asked to provide a yearly rate of change - two percent, three, four, ten?

Caroline Baum at Bloomberg wrote an enlightening commentary earlier today with a "Man on the Street" approach to inflation expectations.

Most people don't have a clue when pressed for a figure.

With confusing media coverage of the plethora of inflation measures trotted out by many different government agencies - wholesale/consumer, overall/core, PCE/CPI, median, and many more - the only data about prices that is easily understood by the public is what they see as they fill up their gas tank.

Whatever its value in formulating monetary policy, the University of Michigan poll on "inflation expectations" and others like it seem to be redundant.

Wonk Talk

With that out of the way, a quick review of last week's events seems to be order. Reuters reported on the speech by Fed Vice Chairman Donald Kohn where he emphasized the importance of "anchoring" inflation expectations in response to the new study.

Of note in the speech were the following passages:

I do not agree with the authors’ assertion that central banks pay too much attention to inflation expectations. Those expectations may not be as much of a leading indicator of the inflation trend as I would like--although I am not sure that I find the paper’s conclusion, that the trend leads expectations, all that persuasive.
...
We should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions.
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In addition, we do not yet have a consensus structural model of inflation dynamics that satisfactorily explains all the important aspects of the empirical data. As the paper demonstrates, a standard workhorse model--a sticky-price business cycle model with a drifting inflation target and a New Keynesian Phillips curve--cannot mimic one important feature of the inflation process. I will leave it to the modelers to debate the seriousness of this deficiency and to propose how it might be rectified. However, it is clear to me that our understanding of the inflation process still has far to go.

The issue of expectations illustrates our ignorance. As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them: Are available measures suitable indicators of true inflation expectations by households and businesses? How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes? And how do expectations influence price and wage setting? In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.

There were other stories on the subject and at least one other speech by another Federal Reserve member, Governor Randall S. Kroszner, but, to be honest, the Kohn speech was enough.

It's not clear that anyone really knows what to expect for inflation, how to measure those expectations, or whether they are important.

The bottom line?

If the Fed thinks that "anchoring" inflation expectations would do some good, then they should get to work on lowering gasoline prices. If recent prices at the pump are any indication, inflation expectations are about to head back up.