See How Do You Feel About Inflation? The Answer Will Help Determine Its Longevity: One factor in inflation is whether Americans expect it to keep rising, but it’s hard to gauge those sentiments by Nick Timiraos & Gwynn Guilford of The WSJ. Excerpts:
"Psychology around inflation is hard to gauge."
"Psychology is one reason the Federal Reserve is likely to signal a faster end to bond-buying and a quicker start to raising interest rates at its meeting this week. “This is about well-anchored inflation expectations,” said Fed Vice Chairman Richard Clarida at a question-and-answer session at the Cleveland Fed two weeks ago. “Getting actual inflation down close to 2% is going to be an important part of keeping those expectations anchored.”
The run-up in inflation this year, to 6.8% in November, has ignited a debate among economists about how to measure inflation expectations. Many argue that long-term expectations are more predictive of behavior than one-year expectations, which are strongly influenced by current prices, such as for gasoline. On that front, they say evidence is more reassuring: Expectations for inflation over the next five years was 3% in December, according to the University of Michigan survey, up 0.5 percentage point in the past year but not much above the average of 2.8% from 2000 to 2019."
"Last year, Fed staff combined many of these measures into a single index of “common inflation expectations” to sidestep challenges in interpreting survey data. The latest index is reassuring. Inflation expectations have risen to levels last seen eight years ago but aren’t particularly elevated. Some economists, however, say that the index’s construction is faulty and that it is too backward-looking."
The Fed and many private forecasters assume consumers adjust their expectations gradually and continuously, implying they’ll have ample warning before inflation expectations become dangerously unanchored. But it’s possible households’ inflation concerns tend to be binary. In other words, they either care a lot or not at all—there’s no in-between.
Harvard University economist and former Treasury Secretary Lawrence Summers is among those warning that a new era of high inflation could be at hand. He said the potentially binary nature of inflation expectations is one reason for his concern. “During a long period of low inflation people toggle off” their sensitivity to inflation, he said, “and we’re in the process of toggling back on.”
Research shows that people tend to ignore inflation when it is low but start paying more attention when it picks up significantly, said Carola Binder, economics professor at Haverford College. The unusually low, stable inflation of the past three decades might have made it hard to tell how well-anchored expectations actually are."
"The labor market will be crucial to watch for signs that workers are reacting to inflation by winning higher wages. As labor demand climbed this year, wages initially rose most strongly for the lowest-paying jobs, then more broadly. One key consideration for economists is whether workers are simply enjoying greater bargaining power, or asking for higher wages in anticipation of higher prices.
Research by Mr. Reis [Ricardo Reis, an economist at the London School of Economics] has found that the distribution of inflation forecasts among households—as opposed to the median—reveals that a minority of households anticipated turning points in the inflationary regime in the 1970s and 1980s early on. Similar dynamics may be taking shape today, said Mr. Reis.
Broader-based wage acceleration could signal that individuals are basing their salary requirements on the inflation they anticipate, said Mr. Reis.
He noted that by the time a wage-price spiral is apparent, it might be too late to rein in inflation by gradually raising rates. More dramatic increases might be necessary, he said, which raises the risk of recession."
"Employers, too, may be building inflation into their behavior. A survey last month of 229 U.S. companies by the Conference Board, a think tank, found firms were setting aside an average 3.9% of total payroll for wage increases next year, the most since 2008."
"The federal government in the 1960s sought to exploit this trade-off, boosting spending on Great Society programs and the Vietnam War without raising taxes, which caused unemployment to drop and inflation to rise.
Around that time, future Nobel laureates Milton Friedman and Edmund Phelps independently theorized there was a natural level of unemployment dictated by an economy’s structure. Monetary or fiscal stimulus could force unemployment below this “natural rate,” but only temporarily. Once people got wise to the resulting higher inflation, they would adjust their expectations and demand higher wages, sending unemployment back up. The theory was borne out by the combination of high inflation and unemployment of the 1970s.
Robert Lucas, another future Nobel laureate, went further. He hypothesized that expectations are shaped by more than past inflation, such as by conjectures about future economic and policy changes. Taken together, this macroeconomic overhaul implied inflation is determined almost entirely by what the public expects it to be over time. Policy makers could influence price developments by shaping those expectations, such as by announcing a numerical inflation target.
The following decades seemed to prove this theory. To rein in double-digit inflation, Fed chairman Paul Volcker threw the economy into a deep recession in the early 1980s. By the mid-1990s, underlying inflation had fallen to around 2%, then fluctuated in that range despite recessions, booms, a financial crisis and oil price spikes. To further anchor expectations, the Fed in 2012 formally set a target of 2% inflation."
"The objective of the new framework was to guide inflation expectations back toward 2%. To that end, Fed officials would seek inflation of 2% on average, meaning years of below-2% inflation would be followed by some period of above 2%. They never specified over what period.
Fed leaders have indicated this ambiguity was intentional because the goal was to nudge expectations up, not some mechanical inflation overshoot for its own sake—for example, 2.5% for three years.
The Fed changed its framework in part because the natural rate of unemployment, which had been key to how the Fed judged inflation risks, had proven too difficult to pin down, causing errors, such as raising rates too much in 2017 to 2018.
Inflation expectations, however, are similarly difficult to pin down, which raises two big risks. The first is that the Fed is right that high inflation will recede on its own, but sharply raises rates anyway out of fear of rising expectations, slowing the economy to head off a nonexistent threat.
The second is that the Fed has been too optimistic about prices cooling on their own, and fails to realize expectations have come unanchored, unleashing a wage-price spiral. In this scenario, that Fed would belatedly slam on the brakes and bring inflation down by causing a recession.
The Fed is hoping to strike a narrow path between those two risks by ending its bond-buying stimulus program by March, giving it the flexibility to raise rates a few times next year while awaiting evidence on how quickly goods prices reverse direction."
This article by Nick Timiraos says: "they [the Fed] want labor market conditions to be consistent with maximum employment, a condition they haven’t defined numerically." (that lines up with the passage from the first article which says "the natural rate of unemployment, which had been key to how the Fed judged inflation risks, had proven too difficult to pin down")
One definition of the natural rate of unemployment is that it is the lowest rate of unemployment compatible with price stability (which the Fed defines as an annual inflation rate of 2% or less).
This graph shows that if we keep increasing AD (either by lowering interest rates, increasing the money supply or increasing government spending), Q (real GDP) will keep increasing which lowers the unemployment rate as firms need more workers.
But the price level (CPI) will keep increasing more and more, meaning higher and higher inflation rates.
SRAS is short run aggregate supply. QF is the full-employment GDP (real GDP). When AD goes past AD2 (let's say we are at AD3 right now), we get significant price increases (the CPI is up 6.8% in the last 12 months). This might be related to where the article talked about inflation expectations being binary. Usually people don't worry too much about it, but now it crosses a threshold and they do care. So they start demanding higher wages.
The article also mentions that workers have greater bargaining power now. So if they demand higher wages, SRAS will shift to the left, reducing Q or real GDP back to QF. Recall that the article said that going past full-employment (or having an unemployment rate below the natural rate) is only temporary. SRAS will shift to the left because the price of a resource (wages, the price of labor) increases and that is a basic shift factor for supply. That lowers Q back to QF.
If workers are expecting higher inflation (which the article also mentions) that also will cause SRAS to shift to the left or decrease. And if wages go up as prices go up, we get SRAS going left while AD goes right. So we stay at QF. The decrease in supply offsets the increase in demand, which is what Lucas talked about above.
But, it is hard to know if this will happen because, as the article discusses, expectations, which involve psychology, are hard to pin down. If workers are expecting high inflation to persist for a while, then they will keep demanding higher wages which will keep reducing supply.
Now if the supply chain bottle necks caused by Covid start to clear up, then costs of production will fall and SRAS will start to shift to the right, which increases Q and lowers P. But earlier this year the Fed said that this was going to happen by now. But it hasn't. So the Fed seems to be thinking that they have pushed AD past AD2 and they need to bring it back with less bond buying and higher interest rates next year.
To see how different things have been in the last 12 months, this table shows the average, high and low inflation rates by decade. The last three decades have had very mild inflation
|
Decade |
AVG |
HIGH |
LOW |
|
1950s |
2.25% |
6.00% |
-0.70% |
|
1960s |
2.53% |
6.20% |
0.70% |
|
1970s |
7.41% |
13.30% |
3.30% |
|
1980s |
5.14% |
12.50% |
1.10% |
|
1990s |
2.92% |
6.10% |
1.60% |
|
2000s |
2.54% |
4.10% |
0.10% |
|
2010s |
1.76% |
3.00% |
0.70% |
Related posts:
The Fed chairman says the relationship between inflation and unemployment is gone
Unemployment Isn’t What It Used to Be: The low rate doesn’t take account of low labor-force participation. Wages are a better indication of slack
The Phillips curve is alive and well (unless it's dead)
Is The Phillips Curve Dead In Japan? Maybe not
Is The Phillips Curve Not Holding Up Well Because The Service And Goods Sectors Are Behaving Differently?
Has the Fed Flattened the Phillips Curve?
Nobody knows what the natural rate of unemployment is today
More on the natural rate of unemployment
How Central Banks Differ In Their Methods Of Calculating Inflation.
Fed Officials Disagree On Threat Of Inflation (from 2009)
Fed Chair Janet Yellen: "there remains considerable slack in the economy" (from 2014)
Fed officials disagree on how much inflation the current low unemployment rate might cause
Fed Looks for Goldilocks Path as Jobless Rate Drops
Is the Phillips curve affected by prices that are acyclical?
What is Full Employment?
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