Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 12 Short Run Macroeconomic Fluctuations
Chapter 35 of 36 The Short-Run Trade-Off Between Inflation and Unemployment
Section 8 of 8
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Central banks try to dampen expectations of inflation to try to keep a better short-run trade-off between inflation and unemployment.
This article here in book.
The Fed Focuses on Inflation Expectations and Tries to Stem Self-Fulfilling Prophecies
By Christopher Conkey, 2005
Over the next couple of days, the U.S. government will issue closely watched estimates of how much prices rose last month at the wholesale and retail levels.
Nearly as important for the Federal Reserve - and therefore, for financial markets and the interest rates that ordinary Americans pay on their debts and receive on their savings - is how much consumers and markets expect inflation to rise down the road.
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Inflation expectations have become increasingly important to monetary policy in recent years.
When people anticipate a rising inflation rate, the prevailing theory goes, they are likely to behave in ways that will bring about higher prices.
If workers anticipate a higher inflation rate in a year's time, they will be more likely to push for higher wages now.
If businesses expect higher inflation, they will be more likely to increase prices sooner.
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Preventing this kind of inflationary spiral is what Fed Chairman Ben Bernanke had in mind last week when he said the central bank will be "vigilant" in combating the recent upward trend in prices.
“The best way to prevent increases in energy and commodity prices from leading to persistently higher rates of inflation is by anchoring the public's long-term inflation expectations," Mr. Bernanke said.
In other words, with the global economy booming and demand for everything from oil to zinc making things more expensive, the way to restrain inflation is to convince people the Fed, through its control of interest rates, will keep it in check.
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Since the great inflation of the 1970s, Fed policy makers have come to view inflation expectations as a referendum on the credibility of the Fed's vow to maintain stable prices.
"If expectations begin to move upward, it's a sign people are losing confidence in the Fed's commitment to price stability," said Laurence Meyer, a former Fed governor who is now at Macroeconomic Advisers, a forecasting firm.
"They are, in a sense, a report card on Fed credibility."
Inflation expectations are more important than ever to predicting what the Fed will do, he adds, because Mr. Bernanke, both as an academic and as a Fed official, has emphasized them so much.
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There are many ways to gauge inflation expectations, commodity prices, bond yields and futures markets all have something to say.
But two measures are particularly useful at times like these.
One comes from a monthly telephone survey the University of Michigan conducts involving at least 500 adults.
The survey asks consumers what they think the annual inflation rate will be over the coming year, and over the next five to 10 years.
Consumers may not be experts in the latest economic theories about inflation.
Academic economists have found, however, responses to the Michigan survey are at least as accurate as, if not better than, inflation projections made by professional forecasters.
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Another measure of expectations comes from the minute-to-minute trading in the bond market, where investors can choose between
- Ordinary Treasury Securities (OTS), which pay a higher fixed interest rate
- Treasury Inflation-Protected Securities (TIPS), which pay a lower interest rate but guarantee a return above the prevailing inflation rate
The TIPS interest rate may or may not ever be higher than that of OTS depending on the inflation rate.
Comparing the yields on the two securities gives one measure of how much investors think prices are expected to climb.
The wider the spread, the higher the expected inflation rate.
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With inflation expectations worsening and other data showing worrisome increases in prices, Fed governors are responding rhetorically.
St. Louis Fed President William Poole said the rise in expectations threatened to "show up in measured inflation in fairly short order," and vowed the Fed would react accordingly.
In a development that surely pleased Mr. Bernanke and his colleagues, the tough talk had the desired effect.
The spread between OTS and TIPS retreated to below 25 percentage points last week.
A victory, perhaps only temporary, in the Fed's battle to "anchor" inflation expectations.
(end of chapter 35)
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Congratulations! 35/36 = 97% of way to becoming competent economist.
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