Why inflation expectations pose risk to monetary policy

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With inflation expectations eclipsing economic slack in driving inflation, policymakers will need to keep expectations in line to avoid “large swings in inflation,” according to researchers at the Federal Reserve Bank of San Francisco.

“Our estimates show that, in the years since the Great Recession, inflation has been driven primarily by public expectations of future inflation rather than by economic slack,” Òscar Jordà vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco, Chitra Marti a research associate in department, Fernanda Nechio a research advisor in the department, and Eric Tallman a research associate in the department, write in an Economic Letter released Monday.

“The increased importance of inflation expectations exposes new risks to standard monetary policy practice,” the authors write. “In particular, it suggests that conducting policy consistently to keep expectations well-anchored to the target is key to avoiding large swings in inflation. When policy is set consistently, the public discounts deviations of the unemployment rate from its natural rate and of inflation from its target as transitory.”

The Phillips curve suggests inflation is determined by economic slack, past inflation, and expectations of future inflation. “The more stretched the economy’s resources are, the more the pressure for prices to rise.”

Over time, each component’s importance has changed, according to the authors. “In particular, maintaining the public’s expectations that the Federal Reserve is committed to an inflation target of 2% has grown in importance over the slack component, in part because realigning expectations is costly to undo. Such considerations are important as the Federal Reserve evaluates its future policy options.”

Inflation responds slowly to factors that determine slack. “This means that inflation is persistent, depending partly on past inflation, thus creating a feedback loop. Moreover, if people believe the central bank is conducting monetary policy to keep inflation at target, they may discount such fluctuations and instead use the targeted level of inflation as their reference point.”

While economic slack and past inflation “have dominated much of the postwar experience” since the Great Recession, “the expectations component has become the dominant factor explaining inflation dynamics,” the authors write.

The connection between inflation and economic slack “has weakened substantially” in the past two decades, also known as the “flattening” of the Phillips curve.

Since Phillips curve calculations are estimates and “the natural rate of unemployment is not directly observable,” the authors used three scenarios to stress test their findings: the first reduced the amount of slack, the second assumed a steeper Phillips curve, while the third looked at “how changes in inflation expectations would modify the dynamics of inflation.”

The first scenario found inflation changed “less than a tenth of a percentage point.” The second model gave a slightly larger increase in inflation — about 0.13 of a percentage point — which left inflation “still quite close to target.”

When inflation expectations were raised to 2.4% from 2% in the final model, it added 0.22 of a percentage point to actual inflation.

“Prolonged changes to inflation expectations thus pose the biggest risk to inflation,” the authors conclude. “A failure to maintain inflation expectations around the target could greatly undermine the Federal Reserve’s ability to achieve stable prices — part of its dual mandate — in the future.”

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Monetary policy Federal Reserve Bank of San Francisco