Inflation Dynamics

Everybody wants to be able to out-guess the Fed concerning inflation in the coming months and years. To do so would require that you have a hard-core, deep understanding of inflation dynamics. In fact, just this past Friday, March 23, 2007, Fed Governor Frederic S. Mishkin presented a speech/paper entitled Inflation Dynamics at the Annual Macro Conference of the Federal Reserve Bank of San Francisco.

At the risk of over-simplifying his arguments, the final final paragraphs of his paper provide at least a little insight into how at least one Fed Governor views the outlook for inflation:

Taken together, the data suggest to me that long-run inflation expectations are currently around 2 percent. That said, I think it should be clear that the evidence points to a range of estimates; moreover, this range is itself uncertain because of the assumptions needed to tease point estimates from the available data. So, although I think that 2 percent is a reasonable estimate of current long-run expectations, I don't want to overstate the precision of this figure. We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate.

If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to be, I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent. This process may take a while in light of the recent rebound in prices for gasoline and other petroleum products. These price increases have boosted the cost of producing many non-energy goods and services, and as firms gradually pass on these higher costs to their customers, monthly readings on the change in core prices are likely to be higher than they otherwise would be. Once this process is completed, however, we might expect consumer price inflation to move into better alignment with long-run expectations and thus settle in around 2 percent. Of course, our understanding of the empirical links between our measures of expected inflation and actual inflation is sufficiently poor that things could well go awry with this forecast. Moreover, many things could happen in the coming months to alter the outlook, as the recent fluctuations in energy markets and swings in GDP growth illustrate.

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment--which I should stress is subject to considerable uncertainty--flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.

As I mentioned at the start, central bankers are acutely interested in the inflation process. This is why I have thought about the topic a lot and chosen to talk about it today. I hope you have found my musings on this subject useful.

In short, the Fed remains intent on pushing inflation and inflation expectations down further, but they fully recognize that the process is likely to take an extended period of time. This is further evidence that rate cuts are not uppermost in the minds of Fed policymakers.

Earlier, the paper noted that "In the case of households, long-term inflation expectations from the Reuters/Michigan survey have been running much higher for a number of years, at around 3 percent." The Fed does in fact recognize that expectations drive behavior of consumers as much as current conditions, but the Fed also notes the "persistent bias found in the short-term inflation expectations reported by this survey." In other words, consumers are rather uncertain about inflation, moderately content with the present, but concerned about the future.

-- Jack Krupansky