The New York Times reports that the Fed is still worried about inflation:
Federal Reserve officials worried that inflation could remain uncomfortably fast, minutes from their December meeting showed, and some policymakers fretted that financial markets might incorrectly interpret their decision to raise interest rates more slowly as a sign that they were giving up the fight against America’s rapid price gains.
I get it. I'm not an economist, and it's easy to heckle from the cheap seats. If I were sitting on the Fed board I might feel more nervous about things.
But the Fed seems to have fallen completely into the rabbit hole of forward expectations. That is, they believe the Fed needs to credibly signal what it's going to do so that financial markets will respond "correctly."
There are some cases where this makes sense, mostly when you're dealing with a recession or a crash. If markets know that the Fed is committed to being a liquidity backstop, they will panic less and be less likely to produce a doom spiral.
But I just don't get the whole "forward expectations" school of thought when it comes to inflation. How are the markets going to respond? Will companies decide not to raise prices? Will workers decide not to ask for higher wages? I've never seen any credible evidence of this outside of hyperinflation episodes.
Rather, I continue to believe that inflation is fundamentally hydraulic. It goes up and down based on underlying movements of the economy, and that's it. These fundamentals might or might not include money supply, interest rates, tightness of labor markets, oil prices, endogenous variables, and so forth, all lagged by various amounts (oil hits inflation quickly, interest rates take a year or so). The Fed controls some of these, but (a) has only a modest impact and (b) has to be aware of lags.
In any case, I have no reason to think that expectations are on this list. Hell, Japan has been trying to raise inflation for years with no luck. And serious economists have taken to saying that nobody understands inflation. If that's the case, then why are so many people enthused about expectations, which strikes me as akin to clapping your hands or wearing a WIN button? It just doesn't work.
But I'm open to argument on this. What's the best shortish piece around on the impact of expectations on inflation?
Expectations of what? I agree it seems implausible that "what the Fed intends to do" has any effect on inflation. But what about one's expectation of how one's boss will respond to a request for a raise? Although this seems hard to quantify, I think many economic models treat it as a quantity that might vary over time and which will have a definite impact. Krugman, e.g., seems to think so: see https://www.nytimes.com/2022/07/19/opinion/inflation-prices-fed.html.
The Fed has been setting expectations and ended up locking itself in a track that is bad policy. Because of that, we'll be talking about 0 or negative interest rates and quantitative easing again in a year to 18 months--unless rates are slashed soon. Of course slashing rates will spook the market, at least in the short term.
The market will soar. A lot of people, especially older baby boomers, are thinking of moving money from stocks to CDs now that yield is up. If the Fed drops interest rates when - not if - the economy collapses, that money will stay in the stock market.
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They said 'markets' and I wonder if they were (are) worried about the stock market and other speculative markets (crypto) running amok? The Buffett indicator hit 200% in July of 2021 and crypto was similarly going nuts. Maybe the Fed sees 'inflation' as an excuse to deflate these bubbles and regain a tool (cutting interest rates) for when they eventually do implode? By most historic markers, the stock market is still wildly overvalued and crypto/nfts are ponzi schemes--It seems like the Fed should find ways to devalue these things before they take down the rest of the economy.
The initial rate increases were needed, along with undoing the quantitative easing. And taking action to pop bubbles, unlike Greenspan, is a good thing. But the current Fed went overboard. Now, they're waiting on lagging indicators to tell them they've killed inflation before they stop raising rates, at which point a recession is baked into the cake.
Here's Brad DeLong on the question:
https://braddelong.substack.com/i/94449519/must-read
The Oliver Blanchard argument he cites, as I understand it, gets to expectations most directly. Essentially that inflation is a series of bargains between different parts of the economy and it doesn't settle until an end to the distributional conflict is forced.
Maybe 2% is just a made up number.
Do "expectations" include all the companies that use inflation as an excuse to raise prices dramatically beyond any actual increase in their costs? When companies report record earnings and profits despite inflation doesn't that indicate they are raising prices excessively?
In a capitalist society, the only price increases that are excessive are those that destroy your market share without concurrent increases in revenue.
So many people miss this point so often-- in a truly market situation, the value of anything is precisely what someone is willing to pay for it at a given time. Notions of intrinsic value are nonsense in that kind of situation, even though intrinsic value is the most normal and natural of human beliefs.
Given the minimal amount of 'true market situations' this notion is also a heavy dose of nonsense.
5 year inflation and 10 year inflation are expected to be around 2.2%.
This comes from looking at the yield of TIPS vs regular Treasury notes.
The numbers have been fluctuating around 2.1% to 2.6% for most of the last year.
The CPI and core CPI are overstated now because of the way they calculate rents (you have written about this).
Our HEADLINE 7.1% inflation is made up of two components. (I've never seen anything as clear as the current situation but I haven't gone back in time to look either.)
The basket of goods went up 6.0% from December through June and then has only gone up 1.0% from July through November. That is how we get the 7.1% for the full year.
The HEADLINE CPI is almost definitely going to go lower every month, with the possible exception of of April (April 22 monthly inflation was only 0.33%), until we get June 2022 out of the 12 months used to calculate CPI.
NONE of this is rocket science. Everyone at the Fed knows this. Everyone on Wall Street knows this. What I don't understand is why neither the Fed nor Wall Street make this point in public.
If we're doing the expectation game, you also have to look at it the other way. If the Fed signals that inflation is high and is expected to stay high for at least the short term then doesn't that change behavior? Workers will be more likely to ask for raises, people will be less likely to save, ... which might lead to inflation.
"or wearing a WIN button". Pullin' up some deep cuts there, Kevin! Hopefully, appreciated by the olds.
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The "Fed sets expectations" dogma is one of many that the Fed operates under and which have never been verified by evidence. Kevin - and some economists, some of the time - are right that the forces that determine inflation are not under the control of the Fed. In particular the Fed has little control over commodity shortages, which have been the main problem this time and were the main problem in the 70's. In fact the Fed's usual action of increasing interests rates can only make shortages worse if it has any effect at all (it does not affect oil and gas supply directly).
Does the Fed increasing the cost of borrowing money spur investors to move away from speculative assets and toward funds that lead to increased commodity production? For example, from stock like Tesla to stocks like Exxon? I know that farmland prices have spiked recently and that has me wondering if the investor class is looking for something safer.
Inflation did subside a lot in the two years after Ford's WIN speech. Maybe Biden should dust that one off. "Back off, Jerome, I got this!"