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Jan. 20, 2022, 9:18 a.m. EST

How can the Fed keep expectations of inflation anchored at low rates?

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Consumer prices  rose  7% between December 2020 and December 2021, the third month in a row that this year-to-year inflation rate exceeded 6%. This December figure is the  largest 12-month increase in 40 years . A central concern now is whether inflation will be transitory or, instead, we are entering a persistently high-inflation period, like what occurred in the 1970s.

The  proximate causes  of current inflation include supply-chain disruptions, labor shortages, and pent-up consumer spending. But another important source of ongoing high inflation is an expectation of high inflation among households and businesses. How does the expectation of high inflation become self-fulfilling, and what proxies do we have to reflect this inherently unobservable but very important economic variable?

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If people expected the 2021 inflation rate to continue for the foreseeable future, a 7% rise in prices would become “built in” as future prices are set and as wage and salary contracts are negotiated.

The Facts:

One source of inflation is when spending by people and companies strains the economy’s capacity for providing goods and services.  Strains on the economy’s productive capacity can arise because of an increase in demand, constrictions to supply, or some combination of these two factors. Currently in the United States and other developed countries it is the combination of high demand and constrained supply that is feeding inflationary pressures.

Demand in the United States was supported through the first year-and-a-half of the pandemic by government support programs. Cash payments to individuals and families under the CARES act of March 2020, the CARES Supplemental Appropriations Act of December 2020 and the American Rescue Plan of March 2021 contributed to  sharp increases in personal disposable income

Spending may also have been boosted by low interest rates, which have increased the value of stocks, houses and other assets. Supply has been constrained because of a 2 percentage point drop  in the share of the population participating in the labor force (either working or looking for a job).

Inflation expectations can sometimes become self-fulfilling.  While some prices can change quickly,  others are adjusted only infrequently ; producers of these goods and services will naturally set their prices based on likely future costs and expectations of what the market will bear in the coming months. Similarly, labor contracts are not renegotiated frequently but instead negotiations set wages or salaries for one or more years at a time.

It therefore matters a great deal how inflation expectations are formed. If people expected the 2021 inflation rate to continue for the foreseeable future, a 7% rise in prices would become “built in” as future prices are set and as wage and salary contracts are negotiated. This would cause inflation to persist even when the economy is no longer “overheating.”

Rising inflation expectations are largely to blame for the persistence of the inflation of the 1970s, which remained  elevated well after the booms of the late 1960s early 1970s had run their course

“Anchored” expectations reduce the risk of persistently high inflation . If people believed inflation would return to its pre-COVID rates once spending cooled and supply-chain issues were resolved, they would assume a slower pace of price increases when deciding on what prices and wages to set today that will prevail in the future.

If firms and workers thought the Fed would manage to bring inflation down from 7% to 4%, for example, they would build correspondingly smaller price increases into their pricing- and wage-setting decisions. With expectations “anchored” in this way, temporary increases in inflation would not become self-fulfilling and inflation would fall more quickly as demand cooled and supply-chain issues were resolved.

The central bank’s commitment to price stability can help anchor inflation.  The Federal Reserve’s mandate, as stated in the  Federal Reserve Act , is to pursue “maximum employment and stable prices.” Until relatively recently, however, these objectives were not spelled out explicitly; nor was there clarity with regard which would take precedence.

But beginning in the late 1980s then-Fed chair  Alan Greenspan made it increasingly clear  that the Fed would prioritize price stability; and in 2012 the Federal Open Market Committee (FOMC) announced an  explicit target inflation rate . These changes are credited with  anchoring inflation expectations and reducing inflation persistence

The Fed’s recent  change in its monetary-policy strategy , specifically the adoption of average inflation targeting, in which inflation is allowed to exceed 2% “for some time” and an increased emphasis on the employment objective,  has raised questions  about the strength of the Fed’s commitment to price stability. The Fed’s credibility may therefore hinge on its handling of the current inflation surge.

Indicators of expected inflation suggest concern but not panic.  Surveys are one source of expectations indicators. One of the most closely watched is the  Survey of Professional Forecasters  (SPF) conducted by Federal Reserve Bank of Philadelphia, which solicits the respondents’ forecasts of inflation over one- and 10-year horizons. The median SPF forecasts are presented in the chart. The one-year forecasts are for the year following the date indicated on the horizontal axis (e.g. the data point for the first quarter of 2010 is the forecast for average inflation from the second quarter of 2010 through the first quarter of 2011) and the 10-year forecasts are defined analogously as corresponding average rate over the 10 years following the date indicated on the axis. Also shown is the percentage change over the previous four quarters in the Consumer Price Index (CPI).

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