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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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The forecasts’ quiescence is striking; once perceptions of the Fed’s commitment to price stability solidified in the late 1990s, the one-year-ahead SPF forecasts have for the most part remained in the 2% to 2.5% range, in spite of large fluctuations in actual inflation. The 10-year-ahead forecasts have been even more stable, suggesting firmly anchored long-term expectations.

Ironically, the very stability of expectations has  made it hard to discern  in the past 20 years’ experience any effects on inflation they might have had. The chart shows that the 2021 inflation spike has had only modest effects on the SPF forecasts so far, as both were 2.6% at year-end.

Although these indicators are reassuring, they are not cause for complacency. For one thing, the forecasts do not incorporate the most recent inflation data, and consequently they are likely to be higher when the next survey is conducted. Another gauge of inflation expectations is a survey of individuals who are not professional economists conducted by researchers at the University of Michigan. In the  survey conducted in November 2021  respondents expected 5% inflation rate over the coming year.

A third way to capture inflation expectations is to analyze financial-market data. For example, a  five-year-ahead expectations indicator  based on the difference between nominal and inflation-indexed bonds is 1.3 percentage points higher now than before the pandemic. Of these three, the SPF forecasts have a record of being most reliable. The Michigan survey’s flaws have been  thoroughly documented  and it has systematically over-predicted actual inflation by 0.8 percentage points during the period from 1999 through 2019. The bond yield-based indicator is highly volatile and  heavily influenced by financial-market conditions .

What this Means:

The 2021 inflation surge has created a great deal of discomfort as many people saw their purchasing power decline as price rises outpaced increases in their income. A longer-lasting period of high inflation could be even more damaging because it would create distortions and disproportionately harm low-income families,  who typically hold a larger share of their assets in the form of cash and checking accounts  as well as those living  on fixed incomes or whose wage or salary increases do not keep pace with price inflation .

One immediate concern is that high inflation will compel the Fed to respond with interest rate hikes that will slow the economy. If expectations remained anchored, only modest interest-rate increases would be required—just enough to bring spending back into balance with the economy’s productive capacity. If, on the other hand, expectations of high inflation were to become embedded, a more aggressive response and significantly larger rate hikes would be required to bring inflation back down, and a recession would almost certainly ensue.

The members of the Federal Open Market Committee (FOMC)  were anticipating, as of Dec. 15, only a small interest rate increase in 2022 , to an annual average of 0.9%, but since then  many are expecting a more aggressive response . This more proactive policy response, intended to keep inflation expectations in check, would be especially warranted if inflation expectations begin to rise.

Kenneth Kuttner is a professor of economics at Williams College, with expertise in macroeconomics, monetary policy, macroprudential policy, and the Japanese economy.

This commentary was originally published by Econofact.org—Thinking Can Make It So: The Important Role of Inflation Expectations

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