Inflation expectations and the Fed

The Fed has begun implementing its new communication strategy. Here’s what the message seems to be.

Noteworthy among the information released by the U.S. Federal Reserve last week was a statement of the FOMC’s longer run goals and policy strategy. A key section reads:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

This represents an important step in the direction of an explicit inflation target, which some academic research suggests might help lead to greater financial stability. It’s very useful to connect this statement of longer run goals with other details released last week on what the Fed is expecting over the next several years. A key takeaway from the latter is the Fed’s expected behavior for the PCE deflator:

Actual and FOMC forecast values for PCE inflation (percent). Source: Federal Reserve.
2007 2008 2009 2010 2011 2012 2013 2014 Longer Run
Actual 3.5 1.7 1.5 1.3 2.5 - - - -
Upper End of Range - - - - - 2.5 2.3 2.1 2.0
Upper End of Central Tendency - - - - - 1.8 2.0 2.0 2.0
Lower End of Central Tendency - - - - - 1.4 1.4 1.6 2.0
Lower End of Range - - - - - 1.3 1.4 1.5 2.0

So the FOMC is saying that it would like inflation to be about 2% annually, but is expecting it only to be 1.4 to 2.0% over the next 3 years. Putting 2 and (less than) 2 together, the FOMC is telling us that, based on its price stability objective alone, the Fed is expecting inflation to be lower than it would like. In other words, even if the economy were at full employment, a little more stimulus would be called for. And of course, nobody thinks the U.S. is anywhere close to full employment. The Fed’s forecast is for an unemployment rate between 7.4 and 8.1% for 2013.

Interpretation: the Fed is expecting to exert some additional stimulus. Large-scale asset purchases– referred to popularly as more “quantitative easing”– are the primary tool available. So, if your motto is “don’t bet against the Fed,” then I wouldn’t bet against more QE during 2012.

But what’s the Fed waiting for? One issue is that although the Fed is expecting inflation to be below target for the next 3 years, and although the actual inflation rate has come in below their announced target over much of the last 4 years, since last April the year-over-year change in the PCE deflator has been running a bit above 2%.

Year-over-year percent change in monthly PCE deflator, 1960:M1 to 2011:M1. Horizontal line at 2.0%. Data source:

The Fed is not alone in thinking that inflation will be lower over the next few years than it was in 2011. For example, the median respondent to the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is anticipating 1.6 to 1.8% annual headline PCE inflation for 2012 and an average over 2011-2015 of 2.1%. A new survey by the Federal Reserve Bank of Atlanta found that businesses in the southeastern United States are on average expecting their costs per unit this year to rise by 1.8%. And expected inflation as inferred from the gap between nominal and inflation-protected 5-year Treasury securities has been coming in below 2% since last summer.

Difference between 5-year nominal and 5-year TIPS yields, monthly averages, 2003:M1 to 2011:M12. Data source:

But although professionals may be inclined to agree with the Fed, ordinary Americans seem less so. The University of Michigan survey of consumer attitudes has been reporting expected inflation rates that are a hundred basis points higher than the professionals.

Federal Reserve Bank of Cleveland.

Why worry about inflation at all, even if the public is right and it turns out to be 3%? Here I think the key question is the limits on what the Fed could do to help. Do higher inflation rates really help the economy, and, once we open that door, could the Fed keep it under control without further economic damage? As long as there is a non-neglible prospect of outright deflation, there’s no question in my mind that trying to get a little more inflation is a good idea. A Fed policy of communicating clearly that they’re simply not going to allow deflation has always made a lot of sense to me. But once inflation goes above 3%, it’s far less clear that more monetary stimulus can do any good.

Could the Fed forge ahead anyway, with a communication strategy of, “yes, we know many of you are expecting higher inflation, but we’re the experts and we say you’re wrong”. Unfortunately, a key element of the success of anything the Fed tries to do is that the market has to believe the Fed can and will carry out what it says. Credibility is the only reason that the Fed’s announcement that conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014″ has any effect at all. For that matter, the market signal that is generated by large-scale asset purchases may be a key mechanism by which QE itself makes any difference. Without credibility, the Fed is only a paper tiger. The more political opposition the Fed faces, the less it can actually accomplish.

The Fed would like to do more, and expects it may soon have to do more. But it isn’t ready to act quite yet.


32 thoughts on “Inflation expectations and the Fed

  1. aaron

    I think the fed and government need to look at the relative price changes and how they affect different demographics in population and dynamics of the economy.

  2. rl love

    “But what’s the Fed waiting for?” I suspect, that… there is a need for the Fin Mins of emerging nations to agree that the U.S. economy at full employment is more important than stable currency markets.
    QE has a closing effect on capital markets and it is exposing the lack of demand for cross-border capital.

  3. Michael Hendrickson

    Recognizing the danger that a higher inflation target could ultimately trigger a wage-price spiral, don’t you think that a slightly higher target (say 3%) could “help the economy” by easing the pressure on those who are under heavy debt burdens? Wouldn’t that assist the process of adjustment toward a more balanced and sustainable financial state of affairs?

  4. Steven Kopits

    Interesting to see the difference between the public and the profession re inflation expectations. I suspect the public is also factoring in price rises, not just inflation, so in theory, the difference between CPI and UM Cons. Att. could be used as one measure of real prices rises. Maybe.

  5. 2slugbaits

    The public’s misperception of likely inflation isn’t helped by politicians and pundits who constantly talk about how the Fed is “printing” trillions of dollars. Of course, the Fed is doing no such thing but the voter-on-the-street believes that’s what the Fed is doing.
    We don’t really know what are the limits of the Fed’s ability to further push economic activity; but I think we can be pretty sure that right now the Fed is nowhere near that limit. So in that sense concern about limits is an interesting, but ultimately academic concern. I’ll be happy when it’s no longer just an academic issue.

  6. dwb

    Bernanke went out of his way several times during the subsequent press conference (listen to it) to emphasize that the Fed is not an inflation targeter and remains a dual mandate institution with equal weights on inflation and unemployment. It is significant that they are now also publishing the central tendency range for the natural rate of unemployment (consistent with full employment and no inflation).
    In fact Bernanke said in response to a question that given its dual mandate, the Fed could allow inflation to temporarily exceed 2% if unemployment were above its natural rate.
    The main reason that the natural rate appears as a range is that it depends on productivity, labor market flexibility, and so on. the logic of the framework implies that if there were a single point estimate for the NAIRU, then there would be a point estimate for rates.
    In other words, the Fed is following a Taylor rule with equal weights on infl. and UE, with a Infl rate target of 2%, and a “soft” UE target of 5.2-6% (depending on what you believe is the current NAIRU). but dont take my word for it listen to the conference.
    The key importance of the “new communications strategy” in my mind is to make the goal clear in order to allow the fed to pursue more balance sheet expansion without diminishing credibility or allowing inflation expectations to become unanchored.

  7. dwb

    PS- as a corollary i think the reason why the Fed has been waiting is that it wanted to take this step to anchor inflation expectations (clearly some on the committee thought more QE would result in inflation getting out of control fore various reasons including due to lack of credibility).
    Bernanke hinted during the press conference that we would know more about the balance sheet forecast and additional measures when the minutes came out.

  8. Rob

    “Ok, what do I buy now that the Fed is going to buy in the future?” Do we not think many analysts are asking that question? Did they say what they are going to buy? Is this also just another disguised bank bailout? Are they waiting to see if the EU goes pop?
    And given that when the Fed does eventually raise interest rates the value of many of the securities it owns will fall implies that it is going to hold those securities to maturity? Or what if they have to mop up excess reserves but don’t have the assets to effectively do so (if they raise rates)–doesn’t that imply a bought of baked-in inflation? Or are we in zirp land until all/most/some of the Fed’s assets mature?
    Too many questions…

  9. MarkS

    I interpret the FED’s discussion of maintaining low interest rates (and parenthetically Quantitative Easing) over the next three years, as a pledge to subsidize Federal fiscal deficits and the banking industry. Obviously, a nasty recession in the US and EU will produce deflationary forces. However, rapid growth in Asia and South America has acted to counter balance it.
    Personally, I think that the current discussion by the FED about inflation is a smokescreen. From the FED’s perspective, current economic conditions require its primary consideration to be on the survival of the current financial system and the government that supports it. The FED will do anything, including hyperinflation, to solve existential problems.

  10. Joseph

    Normally the dual mandate is considered to create the dilemma of favoring lower inflation or lower employment in opposition to each other. It takes a spectacularly incompetent Federal Reserve to undershoot both at the same time.
    In truth, I don’t think that they really are incompetent. They are simply doing the bidding of the bankers who rule over the Fed and the heck with the dual mandate, regardless of Bernake’s empty words. Look to what they do, not what they say.
    We constantly hear that the Fed must be independent, but what that means in practice is that they must be independent of pressure from the public. They respond just fine to pressure from the financial community. Bernanke wrote extensively about using higher inflation to escape from the liquidity trap before taking the job, but obviously is buckling under pressure from his banker colleagues.
    The concept of Fed independence is a fraud. Economists, in general, are not helpful in this situation by adamantly supporting this pretense of Fed independence. This is class warfare, pure and simple, and the lower classes are being slaughtered.

  11. andrew

    Does anybody ever talk about the risks of QE? Is it just a given that if the fed needs to do more, t should just go ahead with more QE? Maybe the risks are outweighed by the benefits, maybe they’re not, but this should be part of the discussion. The fact that it’s not is a poor reflection on this field.

  12. tj

    There are few times I can agree with 2slugs without an if/and/but from me. However, this is one of those times. The inability of some of our political elite to comprehend the money creation process speaks to their inability to govern.
    At the same time, the changes in FED policy since the onset of the Great Recession have been substantial. In my opinion, JDH has become the authority on interpreting and explaining the evolution of FED policy.
    Next time a president looks for a pragmatic replacement for Bernanke, they need to take a serious look at JDH.

  13. mojakus

    “…the FOMC is telling us that, based on its price stability objective alone, the Fed is expecting inflation to be lower than it would like.”
    Actually, if you listen to the press conference, Bernanke said that the achievement of the price stability component of the dual mandate would technically imply a 0% inflation rate. He then mentions that 2% is consistent with a rate that loosely maintains price stability while also allowing the employment component to be achieved. Quite hawkish really.

  14. dwb

    Normally the dual mandate is considered to create the dilemma of favoring lower inflation or lower employment in opposition to each other. It takes a spectacularly incompetent Federal Reserve to undershoot both at the same time.
    One of the benefits of the new communications strategy is that, by making the inflation/UE goal clear, it adds accountability and forces the fed to defend its policy. look at the press conference, several times reporters pointedly asked Bernanke why the Fed was undershooting both mandates, and whether this implied more QE. kudos to Bernanke because in my opinion adding this kind of mandate is a good recipie to keep the central bank on mandate.

  15. Anonymous

    Another round of QE probably won’t be good for stocks. Bonds will break out to all-time highs, the 10 year yield will easily drop to 1.5% and money will chase bonds. SPX puts are okay, MBB and IEF are possibly better.

  16. W.C. Varones

    Normally the dual mandate is considered to create the dilemma of favoring lower inflation or lower employment in opposition to each other. It takes a spectacularly incompetent Federal Reserve to undershoot both at the same time.
    It takes a spectacularly incompetent Federal Reserve to create the Mother of All Bubbles, and to be completely ignorant of the bubble as it was happening.
    Mopping up the disaster they created is tough though.

  17. Joseph

    Mopping up the disaster they created is tough though.
    Yes, I can imagine how difficult their Fed meetings are every few weeks. They realize that on one hand there are 20 million people out of work who are losing their homes, their kids’ college funds, their retirement funds and their health care. On the other hand there is the slight, but currently imperceptible, risk that inflation just might get a little out of hand at some undetermined future date. And they conclude that 20 million ruined lives is a price they are willing to pay to prevent any possibility of future discomfort to their banker friends. They are morally corrupt monsters.

  18. ppcm

    Of course the world need more inflation,how would the output gap be filled without inflation,time as well to wake up the the Philips curve.
    (please see a corrolary of the comment written above by WC Varonnes, why not introduce food and energy in the basket, the inflation target may swiftly be reached..
    The Federal reserve,other central banks may wish to improve their communication, they could explain and quantify the impact of Laspeyres vs Paasche index calculation in the hidden inflation.They may make us privy on the prices giration regarding the international real estates markets.The same Fed was considering sometimes ago to include the estates prices components in the inflation components.The world does definitively need better communication from the central banks and their associates in economics and finance and Davos may not suffice.Considerable time has been spent not only through Econbrowser posts and comments but other professional comments to demonstrate and provide for evidences of ill fated economics models and markets prices distortion and manipulations.Recapturing the ex ante situation of precarious equilibrium, will not be self explanatory for a better future and does require better explanations by the same.
    Tempting as well to revisit Professor B. Aruoba paper Inflation, taxation, and the underground economy, and above declaration of intent while reading the herunder non compounded inflation data. (
    UK inflation
    Italy inflation

  19. CPage

    Should the US start to exhibit above 2% inflation one can be sure Bernanke will be in with Substitution and Hedonics (the US public realise that you can’t eat an i-pad2 and yet hedonics dictates it is deflationary…..)….All irrelevant all Bernanke knows is how to print, lets just hope when the time comes he knows how to drain….

  20. rhabyt

    Is the University of Michigan Inflation Expectation a median or a mean? The latter could be seriously thrown off by a small number of Fox/Paul influenced hyper-inflationistas who put their expectations at 1000%.

  21. MarkS

    PPCM –
    Relative to Aruba’s paper “Inflation, taxation, and the underground economy”…
    My wife’s opinion is that the underground economy grows NOT because tax rates are too high; instead she speculates that people work in the underground economy because they think that the tax system is UNFAIR. I would suggest that she to some degree is probably correct. People support the legal and tax system because they think it is just, not because they think government might offer them contract protection.

  22. Ricardo

    FOMC statement:
    The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.
    If there anyone here dumb enough to believe that the FED gives a flip about its “statutory mandate?” If the FED has to choose between employement (a mandate) and stable prices (a mandate) and sufficient demand for Treasury securities (no where near a mandate) which do you actually believe the FED would choose?

  23. KevinM

    Yes Ricardo is most direct to the point.
    As to the earlier words “The public’s misperception of likely inflation isn’t helped by politicians and pundits who constantly talk about how the Fed is “printing” trillions of dollars.”
    Am I wrong to remember that Ben Bernanke appeared on the popular news show ’60 minutes’ a few years ago and explicitly stated that the Fed was printing money?

  24. Walter Sobchak

    The Fed wants 2% inflation per year and they want to borrow money at 1.84% for 10 years? What is wrong with this picture. Has money lost its time value? Or is the money worthless and just a nuisance for the Fed to park?

  25. westslope

    Is a 2% inflation target credible with 0-0.25% overnight borrowing rates? The implicit target has been 2% for some time now.

  26. Dave

    How can the fed expect to push more mnwy out into the economy when they’re paying interest on banks reserves? Oh, you don’t have anything good to do with your money? Let us keep it for you and give you some more!

  27. Randall Parker

    Maybe the Fed has decided to start trying to sell the desirability of 2% inflation as a prelude to actually implementing policies to bring about 2% inflation. If they can succeed in getting a lot of support for 2% inflation then they’ll take steps to realize it.

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