Monetary Policy & Inflation | US
Should the Fed Forget About Inflation Expectations?
- By Sam van de Schootbrugge
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- 7 min read
Summary
- A 2021 paper by economist Jeremy Rudd explains why inflation expectations should feature less in the Fed’s reaction function.
- Very little empirical evidence suggests inflation expectations affect current and future inflation forecasts.
- Instead, we should look more towards wage growth to explain inflation dynamics, which could imply a higher terminal rate to stabilise prices.
Introduction
Inflation expectations are arguably the most important input into the Fed’s current and future inflation forecasts. The reason is their self-fulfilling nature – if individuals expect higher inflation, prices will follow suit.
That is why central bankers care so deeply about controlling inflation expectations. In official Fed projections, the difference between anchored inflation expectations and runaway inflation expectations could be catastrophic for interest rates and hence the economy. Indeed, rising near-term inflation expectations are likely a key reason for the Fed’s continued hawkish stance (Chart 1).
Given their importance, we summarise a late-2021 Fed paper asking whether inflation expectations should matter so much. It argues that using inflation expectations to explain observed inflation dynamics is unnecessary and unsound – better measures exist, and there is little empirical basis on which to invoke the expectations channel.
Why Inflation Expectations Matter
The New Keynesian Phillips Curve (NKPC) is the most widely used structural model of inflation dynamics. In its simplest form (Equation 3, page 9), it states that inflation today depends on: (i) past inflation, (ii) expectations regarding inflation tomorrow, and (iii) the output gap. This theoretical framework means a predicted relationship exists linking today’s inflation to tomorrow’s inflation expectations.
The idea that inflation expectations affect today’s inflation is a simple one. If individuals act on their beliefs regarding future prices, expectations can lead to self-fulfilling outcomes. For example, a firm’s price today depends partly on expectations about their competitors’ price and demand tomorrow. A worker’s wage demands are related to their beliefs on future purchasing power. A lender sets their interest rate in relation to where they think the policy rate will be. And so on.
Consequently, expectations of higher future inflation lead to higher actual inflation today. And so, the monthly dynamics of inflation expectations provide policymakers with a basis on which to assess the short-term price stability and the policy rate.
However, inflation expectations also have a long-run element. This relates to, but is not constrained by, how well ‘anchored’ expectations are – how much or little incoming data affects them. For example, the less volatile monthly dynamics of inflation expectations are, the more anchored expectations are assumed to be. This anchoring allows central banks to let short-term inflation run hot, knowing inflation should return to target.
Weak Empirical Case for Inflation Expectations
One of the few empirical results in support of including inflation expectations into inflation models is that price beliefs appear to be correlated to trend inflation in the long run (Chart 2). That is, a low-frequency correlation exists between an estimate of actual inflation’s long-run trend and survey measures of long-run expected inflation in the US. This is most notable from the mid-1990s onwards when inflation expectations appear almost completely invariant to changes in economic conditions.
But this stability could equally reflect survey respondents making plausible inflation forecasts in a period of relatively stable actual inflation! This would mean actual inflation governs our expectations, not vice versa as our models stipulate. According to an NBER paper, around two in five US firms use the actual inflation rate to estimate their future expectations.
Also, in recent years and months, movements in inflation expectations have not mirrored changes in trend inflation. Inflation has risen substantially, despite a relatively muted response in long-run expectations. While this may reflect the ‘anchored’ nature of long-run expectations, recent evidence implies this is unlikely.
Moreover, according to the theory, the most important relationship should exist between short-run inflation expectations and actual inflation. This link is also far from perfect. For example, if you chart two-year breakevens versus actual inflation, breakevens almost always underprice actual inflation. Professional forecasters’ short-term expectations are also rarely right and, if anything, lagged (Chart 3).
Beyond the data, there are also shortcomings in the way inflation expectations are derived in the NKPC. And empirical deficiencies exist that make it hard to justify the inclusion of inflation expectations.
If Not Expectations, Then What?
Inflation expectations were convenient additions to pricing models because they helped explain the instability of US inflation from the late 1960s through the mid-1980s. And they could also rationalise the apparent shift towards a mean-reverting inflation process around the mid-1990s.
But, according to the authors, labour cost growth (the difference between wage and productivity growth) can tell a more convincing story (Chart 4). Plotting it against price inflation reveals that the wage determination process is an important feature of inflation dynamics.
To understand this, imagine wages as part of an employer’s attempt to retain workers. If employers pay their workers a wage that falls too far behind the cost of living, they will start to see more quits. That will in turn force them to raise the wages they pay to existing workers (and those they offer to new hires).
In periods of low inflation, workers are less concerned about how their salary changes in relation to the cost of living. However, at some threshold, the rate of change in living costs becomes a pervasive factor in people’s wages. In the mid-1960s, this was when CPI moved up to around 3%, food and home rose 5%, and inflation was advancing in most of its components.
Generally, then, inflation enters a workers’ employment decisions only when the upward movement of prices quickens and extends substantially throughout the whole range of consumer goods and services. Until this point, inflation is not on workers’ radars, and current inflation depends little on past inflation.
What are the Implications?
Expectations, in this rationale, play a much smaller role. The story is instead about outcomes. Workers do not behave this way because they expect low inflation in the future, but rather because they do not view their recent wage increases as appreciably lagging actual changes in the cost of living.
Under this hypothesis, the stability of both observed long-run inflation expectations and inflation’s stochastic trend seen since the 1990s is rooted instead in the wage determination process. Actual inflation was muted because wages adequately compensated workers. In turn, inflation expectations remained constant as agents saw no reason to significantly change their view of the inflation process.
Bottom Line
Translating the results into the here and now, we must look out for wage inflation. As long as wages and quit rates are high, inflation is likely to persist. Also, if inflation expectations play a less important role than central bankers assume, they may need a much higher terminal rate to stabilise prices – closer to 8% is our view.
And this price stability will be hard to achieve. The fiscal nature of today’s inflation has created an unpleasant trade-off for the Fed, and it is likely to need an austerity programme to meaningfully dampen price rises. Moreover, the scale of challenge is near that of the Volcker-era, during which the policy rate increased by far more. So, it may well be that the Fed has many more hikes ahead.
FAQ’s
→ When Will Inflation Go Down?
Inflation will go down when the demand for goods will stop outpacing the supply. According to the IMF, global inflation is expected to decrease in 2023, but it is not expected to fall to pre-pandemic levels anytime soon.
→ When Will Inflation Stop?
Inflation can never be stopped. There is always going to be inflation, although the rate of inflation will vary from economy to economy. Inflation can also be negative (prices decrease), and it is known as deflation.
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.