Federal Reserve officials believe that inflation expectations matter. However, are they accurate about what inflation expectations they should be expecting?
Fed officials seem to agree that the long-term inflation outlook deserves more attention. Fed officials tend to focus on long-term inflation expectations when looking at both financial markets and surveys. It is considered too volatile, and likely reflects recent changes in realized inflation.
It seems to us that this view is not logical for those who have worked too long in central banks or academia. The real world shows that near-term expectations are a significant influence on behaviour and, therefore, economic activity. Yesterday, we noted that three quarters (73%) of people expect inflation to be higher six months from now than it is right now. This could even surpass the recent four-decade highs. We think this view on the part of the overwhelming majority of the public is likely to lead to actions—purchases pulled forward, higher wage demands—that will contribute to inflation in the near term.
It turns out, we’re not the only ones who hold this opinion. A recent note from Bank of America’s Ethan Harris spelled out the bank’s objection to the prevailing view.
“We disagree and think both investors and policymakers should pay more attention to the short-run numbers. We think short-run inflation expectations have not been very useful in recent decades because inflation has been so low and stable. Bouts of inflation have often been associated with energy price swings that then level off or reverse,”Harris wrote.
Harris keeps going:
Surveys on short-run inflation expectancies are telling us something today. People didn’t pay as much attention to inflation when it was low and stable in the past. They set their prices without paying too much. This is the technical terminology. “rational inattention.”However, people are likely to care about inflation over the coming year after months of nearly double-digit inflation and wish to have cost-of living adjustments.
Theoretically, there are strong reasons to focus on 1-year forecasts. In the real world, workers and firms do not base their wage and price demands on what they think general inflation will be 5-10 years into the future—it simply is not logical. What matters is inflation over the life of the contract or agreement—the next year or so, not five years ahead!
The Federal Reserve is adamant that only long-run projections matter. This dogma seems to be despite the fact that long-run inflation expectations are often lower than actual inflation, and short-run forecasts being more accurate.
Tomorrow’s announcement by the Fed regarding an interest rate increase will be made. Most people agree that the Fed will raise Federal Funds’ target interest rate by 75bps. Markets are pricing in a 18 percent chance for a larger increase. In this instance, we believe the consensus is correct. Jerome Powell, Fed Chief, would however be wise to speak out in a really hawkish tone at the press conference, to dampen the possibility that the Fed will reduce rate increases this year. Instead of stepping down from 50 to 25 and then back up to 75, the correct policy would be for inflation to not recede significantly.
The full article is available here here