Grim expectations of Inflation

Economics focus

Grim expectations

Jun 26th 2008
From The Economist print edition

Expectations of inflation have risen. How worried should central bankers be?

IN 2002 John Taylor, a well-known monetary theorist, gave a speech in honour of Milton Friedman, the great economist who died in 2006. Mr Taylor described how the low and stable inflation of the previous two decades emerged from a more disciplined monetary policy, inspired in part by Friedman’s analysis. “In the United States when the inflation rate approached 4% in 1968, the federal funds rate was about 5%. When the inflation rate approached 4% in 1989, the federal funds rate was about 10%, clearly a much larger response.” Once again, America’s inflation rate is at 4% but the fed funds rate is just 2%. With inflation high and interest rates low, many are worried that the lessons set out by Mr Taylor and by Mr Friedman before him are being ignored.

If policymakers have until recently seemed remarkably relaxed about higher inflation, that is because it reflects a jump in the cost of oil and food rather than a broad acceleration in prices. When commodity prices shoot higher, the standard policy response is to treat the resulting rise in inflation as a once-and-for-all shift in relative prices. An interest-rate increase big enough to squeeze inflation back down in short order would cause a needlessly large rise in unemployment. As long as expectations of future price changes are stable, policymakers can breathe easily. Firms and workers are unlikely to push other prices and wages higher, and so the surge in inflation will soon pass.

This textbook account puts expectations at the heart of the inflation process. Until recently, central bankers have looked on the stability of inflation expectations with satisfaction. The public seemed to trust that independent monetary stewards would not be tempted, as politicians might be, to keep interest rates too low to control inflation. Now, however, inflation expectations have started to pick up sharply, which is putting the credibility of central bankers to the test. On June 25th the Federal Reserve’s open-market committee kept American interest rates on hold. Though it acknowledged that upside risks to inflation and inflation expectations had increased, it gave no hint that higher rates were imminent. This suggests that inflation expectations are, perhaps, not as central as they were once assumed to be.

There are two main ways of divining expected inflation, each with its own flaws. The first is to ask people what they think the inflation rate will be. Recent replies are worrying. A survey by the University of Michigan shows that inflation is expected to be over 5% in the next year, the strongest reading since 1982. In Britain expectations have risen to their highest level since the central bank’s survey began in 1999. A poll of the euro area, done by the European Commission, also shows a rise in the balance of consumers expecting higher inflation (see left-hand chart, below).

One reason to question these shifts is that consumers’ perceptions often differ from reality. Expectations shot up in the euro area around the time when retail prices were first quoted in the new currency, but the feared inflation never materialised. Consumers may be overly sensitive to changes in the price of frequent purchases, such as food and fuel, while they overlook the stability of other prices. As the effect of the commodity shock fades, expectations are likely to follow recorded inflation back down again. Another frequent complaint is that expectations are usually measured one year ahead when, arguably, what matters are people’s beliefs about medium-term inflation. Then again, where indicators on these are available, there are hardly encouraging. Expected inflation for the next five to ten years is 3.4%, the highest since 1995, according to the Michigan survey.

Measures derived from financial markets may be less volatile, but have shortcomings of their own. An established gauge is the yield gap between conventional and index-linked bonds. Inflation expectations are implied by the extra return investors demand to forego protection against future price increases. On this basis, they are increasingly nervous about the inflation outlook in the euro area and especially in Britain (see right-hand chart, above).

One problem with such gauges is that they are based on nominal bond yields, which include a risk premium for inflation’s volatility. Another is that the pool of index-linked bonds is much smaller, and thus less liquid, than that of regular bonds. When investors are nervous, they will accept lower yields in exchange for the liquidity that conventional bonds offer. This pushes down implied inflation rates, particularly in America’s bond market. The Federal Reserve Bank of Cleveland publishes a series which, after adjusting for these inflation-risk and liquidity premiums, lifts expected inflation to 3.3%, from 2.5%. By contrast, market-based measures in Britain may exaggerate inflation fears. Pension funds are eager buyers of index-linked assets, because the rules require them to buy securities to match their commitments to protect some pensioners against inflation. That pushes down real yields and pushes up implied inflation expectations.

Dragging anchor

However imprecise the measures of inflation expectations, central banks in America, the euro area and Britain have all said it is important to keep them anchored. But in a speech on June 9th Ben Bernanke, the Fed chairman, admitted to gaps in knowledge about how the actions of central banks affect inflation expectations and how these affect inflation. The focus is usually on the threat of a wage-price spiral. Since workers care about real wages, expectations of higher inflation may lead to bigger wage claims, push up employers’ costs and create the very inflation that employees fear. Yet little is known about what firms expect inflation to be and how, if at all, these beliefs influence pricing decisions.

If an inflation psychology is returning, not all the rich world’s central bankers appear to be treating it with the same degree of fear. Only the European Central Bank has signalled that it will raise interest rates. Its American and British counterparts may be right in judging that inflation expectations will be attenuated by an economic slowdown, and flexible labour and product markets. If they are not, they run the risk of squandering the credibility their predecessors earned at such a high price.