Those of us who spend time at central banks are often reminded by our hosts "“ or perhaps they are seeking to reassure us "“ that inflation expectations are "well anchored." Looking over longer horizons, at least, it would appear they are: A history of the Michigan survey of inflation expectations (see Chart 1) shows five-year-ahead expectations over the past fifteen years have fluctuated very modestly. Why is this important?
With Inflation, Expectations MatterSince the pioneering work of Milton Friedman and Edmund Phelps in the 1960s, economists have known that public expectations of future inflation are an important determinant of actual inflation. So important, in fact, that the substantial economic costs of bringing down high inflation "“ lost GDP, elevated unemployment "“ are largely the consequence of the need to bring down inflation expectations that are stubbornly embedded in wages and costs after a period of high realized inflation.
In the early 1980s, Federal Reserve Chairman Paul Volcker's monetary policies ultimately "broke the back" of U.S. inflation and, crucially, inflation expectations as well, setting the stage for a quarter century of robust growth interrupted by only two relatively brief and mild recessions. His successors, Alan Greenspan and Ben Bernanke, benefited mightily from Mr. Volcker's legacy and were able to pursue nimble and successful monetary policies that could focus on keeping inflation low and stable without the imperative to undertake again the much more onerous task of breaking its back.
Expectations Can Also Aggravate a Deflationary TrendBut just as there is a large economic cost involved when implementing disinflationary policies in response to surging inflation expectations, there is also a potentially large cost involved in allowing deflation to persist (or worsen) when inflation expectations collapse: Witness the experience in Japan since the 1990s. Deflating economies rarely prosper "“ there is a reason the phrase "the Go Go 1930s" never did enter the lexicon "“ and deflating financial systems often founder as nominal financial obligations incurred earlier (the Go Go 1920s?) when inflation was positive are much more difficult to service when prices, wages, revenues and profits are stagnant.
In addition, deflation itself can complicate policymakers' efforts to engineer the reflation that can pull the economy out of its deflationary trap, a trap in which expectations of future deflation beget ongoing deflation. Central banks are limited by the zero lower bound on the short-term policy interest rate that in normal times they adjust to keep inflation close to target and output close to potential. At the zero bound, which many major central banks bumped against in darkest days of the financial crisis, the remaining monetary policy options available are all "unconventional": quantitative and credit easing, unsterilized foreign exchange intervention, or providing banks unlimited liquidity against a wide range of unorthodox collateral.
Unconventional measures helped stabilize the global economy after its collapse in the winter of 2008"“2009 and, since then, have continued to support an ongoing if uneven recovery in global economic activity. However, these policies were not implemented without concerns about their actual or potential collateral costs. Most, if not all, central banks that recently enacted unconventional monetary policies are seeking to exit from them at the earliest appropriate time "“ and immediately communicate to the markets their strategy for doing so.
Stable Inflation Expectations Contributed to the Great Bull Market in Bonds Returning to Chart 1, it is not a coincidence that the "great disinflation" also set the stage for the great bull market in bonds that lasted from the early 1980s to roughly the end of 2010. Over time, as the public became convinced inflation would remain low and stable, bond yields fell, and most of the inflation premium embedded in interest rates evaporated; it was no longer required to persuade investors to hold longer-term bonds.
Note also how during the great disinflation, from roughly 1981 to 1995, it was long-term inflation expectations that converged to short-term inflation expectations. In retrospect, the market seemed to be saying, "I'm from Missouri: Show me." And as the Fed succeeded in bringing down actual inflation, short-term inflation expectations adjusted first, followed only after a lag by longer-term inflation expectations.
However, since 2001 the pattern has been exactly the reverse. Short-term inflation expectations have been very volatile, with numerous spikes in both directions, though they appear to revert to the mean quite promptly. To date, longer-term inflation expectations have been relatively stable. The stability of inflation expectations in many countries around the world was a blessing to policymakers during the crisis and early recovery, because central banks could focus monetary policy on stabilizing collapsing economies without worry these policies would be reflected in higher longer-term inflation expectations.
But Be Careful Drawing Conclusions that Expectations are Well Anchored It is indeed important that inflation expectations be well anchored and at a level consistent with each central bank's desire to achieve, on average over a cycle, low and stable realized inflation without undue volatility in output and with employment near its potential. Survey evidence on inflation expectations, such as the Michigan data, as well as forward breakeven inflation data from the inflation-indexed bond market, shows that long-dated inflation expectations are (and have for many years) been remarkably stable.
From that evidence, it is tempting to jump to the conclusion that two decades of successful monetary policy have anchored inflation expectations and that these well-anchored expectations serve as a bulwark against U.S. inflation diverging toward either high inflation or Japan-style deflation. Indeed, as recently as October 2010, the Fed's primary concern was deflation risk: According to a standard Phillips curve analysis of the time period since the financial crisis began in 2008 (based on the historical inverse relationship between the rate of unemployment and the rate of inflation in the U.S. economy), given such a large output gap, the only thing keeping the U.S. out of deflation was well-anchored inflation expectations. In fact, in a mid-October FOMC conference call, members discussed the merits of moving to a price level target as a way to better anchor inflation expectations well north of zero (source: Federal Reserve minutes). The Fed chose not to go down this path, possibly because the second round of quantitative easing was sufficient to stabilize and in fact increase inflation expectations.
But do we know for a fact that inflation expectations are well anchored? I believe not, at least not in the traditional meaning of the expression. All we really know is that longer-dated measures of inflation expectations have appeared to adjust slowly to the ebbs and flows of the business cycle and to spikes or declines in realized inflation associated largely with commodity prices and the pass-through of large exchange rate moves to import prices.
Stability of Inflation Expectations: Optimistic vs. Pessimistic ExplanationsThere are two competing explanations for the observed stability of longer-dated inflation expectations "“ and they have very different implications for monetary policy. I think of them as the optimistic policy credibility view and the pessimistic inflation inertia view.
According to the optimistic view, inflation expectations are largely, if not entirely, forward looking. Thus, the fact that longer-dated expectations have fluctuated only modestly during this business cycle is the result of the Fed's credibility in assuring that inflation will reach and remain, on average, close to 2%.
By contrast, according to the pessimistic view, inflation expectations appear to have a significant inertial component (sources: Jeffrey Fuhrer and Gerald Moore, "Inflation Persistence" (1995), and N. Gregory Mankiw and Ricardo Reis, "Sticky Information Versus Sticky Prices" (2002)). Thus, the modest adjustments in longer-dated expected inflation may not be the result of Fed credibility to generate and moderate inflation in the future, but instead may only be the result of the Fed delivering 2% inflation in the past. Under this view, if inflation were to rise and stay well above current levels for some time, as it has in the U.K., expectations of rising inflation could become entrenched in longer-dated expectations. That is, we could see a return to the pattern observed during the great disinflation, with long-term inflation expectations converging to short-term expectations. And we perhaps already see some evidence of this over the past few months (see Chart 1).
The truth is we really don't know if longer-term inflation expectations are well anchored. We just know they tend to adjust slowly to actual inflation. That's the good news. The bad news is once expectations have adjusted upward, it is hard to believe it will be easy to bring them down again. Unless, of course, you are an optimist.
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