Fed Chair Ben Bernanke’s comments Tuesday about anchors for expected inflation left some analysts unsettled and others mystified. Bernanke was speaking to a group of academic researchers, and I believe his message was intended to provide some insights from practical policy-making to help improve the quality of academic research. So let me offer my interpretation of his message.
Here’s part of what the Fed Chair said about inflation expectations anchors:
long-run inflation expectations do vary over time. That is, they are not perfectly anchored in real economies; moreover, the extent to which they are anchored can change, depending on economic developments and (most important) the current and past conduct of monetary policy. In this context, I use the term “anchored” to mean relatively insensitive to incoming data. So, for example, if the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.
One of the academic studies that Bernanke mentioned in support of this view appeared in the American Economic Review in March 2005 by Refet Gurkaynak, Brian Sack, and Eric Swanson, which is also one of my favorite papers. The authors’ conclusions are based in part on analysis of forward interest rates, which are the future interest rates implicit in the yields available on bonds of different maturities today. For example, consider for simplicity bonds that paid no coupon but compensate you entirely through a future redemption value that is higher than the price you pay today. Suppose you simultaneously bought some 10-year bonds and sold some 9-year bonds with an equivalent current market value. You won’t have any net receipts in or out until 9 years, when you’re obligated to pay the redemption value for the 9-year bonds, and then at 10 years, when you receive the redemption value for the 10-year bonds. In effect, you’ve set yourself up to make a 1-year investment 9 years from now, at terms you lock in today. The interest rate on that investment is known as the 9-year forward rate, which is a number that can be calculated from the current 9-year and 10-year yields.
Gurkaynak, Sack, and Swanson then looked at how forward rates of different maturities respond to economic news, for example, comparing how much the 4-year forward rate (an implied 1-year interest rate you could lock in for 4 years from now) changes today in response to the extent to which analysts were surprised by today’s nonfarm payroll number. The responses of the n-year forward rate to a few of the news variables they looked at are plotted below as a function of n, along with 95% confidence intervals. For example, the bottom right panel shows that if nonfarm payroll employment today is higher than expected, the implicit forward rate becomes higher for essentially as far ahead as one can see.
It is surprising that such a noisy, short-run signal as the NFP has any implication for something so far into the future. The same phenomenon was quite in evidence this last week, as we saw 10-year yields jump on the favorable ADP and NFP employment reports, only to come back down this week on new pessimism about retail sales:
Gurkaynak, Sack and Swanson also analyze a standard model of the economy to illustrate why it’s difficult to account for such a strong long-run response to short-run news. If the Federal Reserve is facing a short-run tradeoff between inflation and output, but its long-run ideal rate of inflation is constant over time, Gurkaynak, Sack and Swanson’s calculations suggest that it would be impossible to generate such a big response. The authors conclude that instead the Fed’s long-run target for inflation is constantly changing, and markets are continually changing their opinion about where the Fed is going to take us next.
But Bernanke was telling the academics that as an insider he doesn’t buy that interpretation. He knows that his own long-run target for inflation hasn’t budged a tenth of a percent since he took over the Fed’s reins. He instead urges us to look at models in which people are continually changing their minds about how the economy works:
The traditional rational-expectations model of inflation and inflation expectations has been a useful workhorse for thinking about issues of credibility and institutional design, but, to my mind, it is less helpful for thinking about economies in which (1) the structure of the economy is constantly evolving in ways that are imperfectly understood by both the public and policymakers and (2) the policymakers’ objective function is not fully known by private agents. In particular, together with the assumption that the central bank’s objective function is fixed and known to the public, the traditional rational-expectations approach implies that the public has firm knowledge of the long-run equilibrium inflation rate; consequently, their long-run inflation expectations do not vary over time in response to new information.
In addition to the research papers that Bernanke cited, I might also mention an interesting
study by Northwestern University Professor Giorgio Primiceri which appeared in the August 2006 issue of the Quarterly Journal of Economics, which argues that it is the Fed itself that is learning about the economy, and in particular miscalculations by the Fed were a big part of the story behind the surge in inflation in the 1970s. Bernanke perhaps is also a fan of that paper, but may feel constrained about endorsing its conclusion openly.
In any case, it seems the market is still trying to learn about Bernanke. And I still say the truth is pretty simple– the Fed now does have a very good understanding of inflation, and is not going to tolerate a resurgence.