When confidence in the Fed wanes, inflation prophecies become self-fulfilling
By Paul H. Kupiec
The Federal Reserve has long held the view that public confidence in its inflation-fighting credibility is the key for a successful non-inflationary monetary policy. If firmly-anchored inflation expectations are indicative of a well-calibrated monetary policy, the Fed’s current policy stance is misguided. Inflation expectations are well above the Fed’s 2 percent target rate and there is evidence of an emerging wage-price inflationary spiral. Given the current accommodative stance of monetary policy, strong consumer demand, continuing supply chain disruptions, and the reality that it will be months before the Senate confirms Federal Reserve leadership and the Fed takes decisive action, inflationary pressures are unlikely to subside soon.
Well-anchored inflation expectations are the “holy grail” of the Fed’s inflation-targeting regime. If the public’s inflation expectations remain anchored, the Fed will not tighten monetary policy to offset a transitory spike in inflation. This view was clearly articulated by Federal Reserve chairman Yellen in 2015:
The presence of well-anchored inflation expectations greatly enhances a central bank’s ability to pursue both of its objectives — namely, price stability and full employment. Because temporary shifts in the rate of change of import prices or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation. As a result, the central bank can “look through” such short-run inflationary disturbances in setting monetary policy, allowing it to focus on returning the economy to full employment without placing price stability at risk.
In other words, businesses, households, and investors will not react to a transitory spike in inflation if they trust the Fed to adopt an appropriate monetary policy to effectuate its long-run inflation target.
If reliance on “anchored long-term inflation expectations” as the primary mechanism for keeping inflation in check strikes you as the monetary policy equivalent of a Jedi mind trick, that is because it might well be. Economists have no proven theory that explains how businesses and households form their inflation expectations. There is really no evidence that the pre-pandemic experience of low stable inflation rates reflects the public’s faith in the Federal Reserve’s inflation-fighting chops. There are other plausible theories of expectations formation that are not so forgiving in the face of transitory inflation rate shocks.
There are economists at the Fed and elsewhere who believe that long-term inflation expectations adapt in a manner consistent with bounded rationality. Expectations may have appeared to be firmly anchored around the Fed’s 2 percent inflation target because inflation had been close to or below 2 percent for more than a decade — low enough that inflation has not been a very important consideration impacting household and business decisions. According to Rudd (2021),
The recent historical period with “anchored inflation expectations” could represent, “one in which inflation isn’t on workers’ ‘radar screens’ anymore (or is at least is only a very tiny blip), which in turn yields an outcome where current price inflation does not respond (much) to past inflation (because inflation is not a major factor in wage determination).”
Under this bounded rationality view, if inflation should spike above a narrow range around 2 percent, businesses and households would begin to focus on inflation and reassess their expectations regarding future inflation. This seems to be exactly what is happening. The following chart shows household expectations for future inflation as measured by a survey conducted by the Federal Reserve Bank of New York.
Not only are businesses and households indicating they expect higher inflation in the coming years, they are changing their behavior to reflect their new inflation outlook. Workers are quitting their jobs at historically high rates in search of higher pay as business entice applicants with higher wage offers and signing bonuses as they try to fill millions of vacant positions. Unions are once again including cost-of-living wage adjustment clauses into long-term labor contracts. Recent contracts negotiated by workers at Kellogg Company and Deere & Company include cost-of-living clauses that inflation-adjust wages every three months. In addition, many states’ minimum wage laws include annual inflation adjustments to the mandated minimum wage. These developments are reminiscent of the wage-price spirals that characterized the Great Inflation that plagued the Nixon, Ford, and Carter administrations.
Rather than reflecting confidence in the Fed’s inflation-fighting resolve, the apparent pre-pandemic stability of long-run inflation expectations may have reflected the fact that, until recently, the public had no reason to revise its inflation expectations. Today, however, there is no doubt that households and businesses recognize the pandemic-recovery surge in inflation. Not only has the experience jolted them into rethinking their expectations for future inflation, they are changing their contracting behavior in ways that will make these new expectations self-fulfilling. The longer this persists, the more likely it will require a deep Fed-induced recession to break the inflationary spiral.
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