The Federal Reserve is convinced that inflation expectations are extremely important. But are they right about which inflation expectations?
The consensus view among Fed officials appears to be that longterm inflation expectations deserve the most attention. When Fed officials look to both surveys and financial markets to glimpse inflation expectations, they tend to emphasize three year and five year and even ten year time scales. The near term is downplayed as too volatile and probably just a reflection of recent moves in realized inflation.
This strikes us as a point of view that only makes sense to people who have spent too much time in academia or central banking. In the real world, near term expectations have a very big influence on behavior and therefore on economic activity. Yesterday we pointed out that around three-quarters of the public expect inflation will either be running at a higher rate six-months from now or even with the four-decade high levels of recent months. 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.
Fortunately, it turns out that we are not alone in this view. 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 continues:
Today, surveys of short-run inflation expectations are probably telling us something. When inflation was low and steady, people likely did not pay much attention to general inflation in setting their own prices. The technical jargon for this is “rational inattention.” By contrast, after many months of almost double-digit inflation, many people likely care a lot about inflation in the next year or so and want to be protected with cost-of-living adjustments.
There are also strong theoretical reasons for focusing on one-year expectations. 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!
Unfortunately, the dogma that it is only the long-run expectations that matter reigns inside the Federal Reserve. Even the recent history of long-run expectations under-anticipating actual inflation and short-run expectations being a better guide seems to have made no dent in the adherence to this dogma.
Tomorrow afternoon the Fed will announce an interest rate hike. The consensus view is that the Fed will raise the target rate on Federal Funds by 75 basis points. The market is pricing in around an 18 percent chance of a bigger hike. We think the consensus view is likely right in this case. Fed Chief Jerome Powell would, however, be well advised to publicly take a super-hawkish stance at his press conference in order to put a damper on the notion that the Fed will slow down rate hikes this year. The correct policy is likely 75 basis point hikes through the end of the year, rather than a stepping down to 50 and then 25 despite inflation not significantly receding.