Anchors away
The Fed says inflation expectations are anchored, but it worries they won't stay that way. What does that mean and why is it important enough to risk millions of jobs?
Inflation in June was bad. Anyone who filled up their gas tank, bought groceries, or signed a new lease knows it. They did not need the CPI to tell them, but tell us it did. High inflation means the Fed is failing to keep prices stable, and there’s a risk that high inflation today could create high inflation tomorrow and so even more hardship.
Today’s post is about the risk that high inflation begets high inflation. Excluding food and energy, inflation is stepping down, but it is excruciatingly slow and uneven, and above all, it remains high. Total inflation is worse. Energy is a complete disaster, food is not much better, whipsawing us around, and we are far from back to normal.
O, Captain! My Captain!
Inflation worries the Fed a lot, and inflation expectations do too. Each new data point from the Michigan Survey, which is the longstanding source of household expectations, looms large at the Fed. Sentiment in the survey has plunged, but a wiggle on the line below helped justify the largest rate increase since the 1990s.
Here’s Fed Chair Powell in June on inflation expectations:
Headline inflation is important for expectations. People—the public’s expectations, why would they be distinguishing between core inflation and headline inflation? Core inflation is something we [on the Committee] think about because it is a better predictor of future inflation. But headline inflation is what people experience … that’s—expectations are very much at risk due to high headline inflation … Hence our resolution to get rates up.
On the one hand, his statement is obvious. Gasoline prices loom large in the survey expectations, especially the near-term ones. It’s the price we stare at the most. On the other, his punchline is frightening. Instead of looking through those moves in expectations due to energy, the Fed will use them as a guide to monetary policy.
That’s not in the playbook, for a good reason. Energy inflation is a supply problem, not a demand problem. The Fed has the tools to lower demand, not to increase supply. Plus, these prices are volatile. Congress and the White House should heed the warning, pass energy legislation, and do anything else, actions, not tweets, to get those prices down. You do not want Jay to carry through on that promise. He will.
Anchors away
The focus on inflation expectations is not just a Fed thing; it’s a macro thing. In standard theory today, inflation expectations play a huge role. To the point that they, not actual inflation, cause future inflation. (Hi, Covid and Putin.) And it’s the Fed's credibility as an inflation fighter that keeps them anchored. (Hi, endless speeches.)
An alternate view, more popular in the past, is that inflation expectations evolve primarily based on recent inflation, not what the Fed says it wants. Reality backs that up. Here is research by Sandor Axelrod, David Lebow, and Katia Peneva at the Board:
The overarching summary is that inflation perceptions look similar to inflation expectations. The central tendencies of the responses for perceived inflation over the past five to ten years are similar to those of expected inflation for the next five to ten years, and all are a little above official estimates of inflation. Thus, survey respondents overall do not expect long-term inflation to change in the future relative to the recent past ... These results suggest that if inflation perceptions were to change, they could lead inflation expectations to change as well.
Expectations do not turn on a knife’s edge like the latest macro theory. And we have had a year of high inflation, not a decade of it like the 1970s. Even so, their research suggests that the longer people live with high inflation, the more likely their expectations are to drift up. The Fed can’t talk inflation down. It must deliver. That’s exactly what it is trying to do. The Fed should not have to do it all:
Inflation expectations could change behavior in a way that creates more inflation. In countries with hyperinflation, it happens, and in the 1970s, it did some too. Households who expect prices to rise may buy more now before prices rise; they also save less and borrow more; workers demand higher wages, and firms raise prices. That’s an inflationary spiral. We are not there now and don’t want to get there.
Alan Blinder, a former Vice Chair at the Fed, sums it up well:
Arguing that inflation is always and everywhere an expectational phenomenon is no better than arguing that inflation is always and everywhere a monetary phenomenon. Yes, expectations matter. But so do other things.
Keep an eye on expectations, but don’t lose it over a couple of tenths on consumers’ expectations or jump for joy when break evens (markets’ expectations) drop. It’s actual inflation and actual behavior that should keep us up at night. It does.
Inflation is like the ocean; it goes up and down
The high inflation we are living with today will pass one way or another. If the Fed leads, it will be painful. The low pain way is more supply and demand shifting to where there is more supply. Consumers with less pent-up demand and more price sensitivity (hi, Walmart nation) would help too. High prices are the best cure for high prices. But those adjustments are slow; the Fed is fast. Lower inflation, if it comes too fast, will come with a nasty surprise for workers. We don’t need a severe recession; we need something to go our way in the world for once.
Wrapping up
The Fed is navigating treacherous waters and trying not to sink the ship. Anchored to the bottom of the ocean is not its goal. I don’t agree with every decision, and I am concerned the Fed’s leaning too hard on inflation expectations. Even so, I get it and am generally on board with their choices. Inflation is high, and it’s a hardship. The Fed doesn’t want unemployment any more than the rest of us, though they may cause it. Fed officials are doing the best they can. That’s all we can ask.
If the Fed’s aggressive stance increases U-3 by 50bps, is the “Sahm Rule” more like the Taylor Rule or the Heisenberg Principle? Is it an observation or closer to a law of nature?