DON'T UNDERESTIMATE THE EFFECT OF INFLATION EXPECTATION DATA ON THE FED.
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By Brian Blackstone
Of DOW JONES NEWSWIRES
WASHINGTON (Dow Jones)--Though U.S. inflation has been low the past two decades, policymakers must remain mindful of the possibility of a self-fulfilling "trap" should higher price expectations get embedded in the economy, according to a recent paper written by two Federal Reserve economists.
"Expectation traps should be considered more than just a theoretical possibility," Roc Armenter, economist at the New York Fed, and Martin
Bodenstein, economist at the Federal Reserve Board, wrote in a research paper.
"After more than 20 years of low inflation in the U.S., the study of past high inflation episodes may not seem a pressing issue. We think otherwise," they added.
The paper, titled "Can the US Monetary Policy Fall (Again) In An Expectation Trap?" and dated May 10, 2006, was posted on the Fed's Web site Tuesday.
The economic model used by the Fed economists concludes that the U.S. essentially operates at two "equilibrium" inflation rates: 2%-2.5% and just over 10%. Based on their model, "any economy with a 2% equilibrium inflation rate has a high inflation equilibrium as well," the authors stated.
The inflation rate hovers in the 2% to 2.5% range - as it has in the U.S. in recent years - when firms with significant pricing power conclude that inflation is going to be low and, assuming the Fed validates that view, then interest rates stay low to the benefit of rate-sensitive firms that must borrow to meet wage and other costs.
But it works the other way, too. If companies with pricing power expect inflation to rise and in turn set their prices higher, then expectations of higher prices breed into reality, pushing 2% inflation rates to double-digits.
Central bankers then face a dilemma: either validate inflation expectations by allowing prices to elevate or take action to lower overall inflation, which would give firms with significant pricing power an even bigger advantage.
Under that reasoning, it was an inflation xpectations "trap," and not higher oil prices, that led to double-digit inflation in the 1970s. And it did so quickly. As Armenter and Bodenstein noted, "the high inflation of the 70s was preceded by a decade of low inflation."
They called their findings "an important step forward in exploring the hypothesis that the high inflation experienced by the U.S. in the 70s was driven by expectations."
"The possibility of a high inflation equilibrium is a first order concern for the policymaker," Armenter and Bodenstein wrote.
Indeed, officials in recent weeks have stressed the importance of keeping both inflation and inflation expectations under wraps.
And with financial markets split as to whether the Fed will continue raising interest rates, investors have become increasingly sensitive to inflation readings - evidenced by the negative reaction to a recent report showing core consumer price inflation in April coming in 0.1 percentage point above expectations, at 0.3%.
Wall Street anxiously awaits another price report Friday - the personalconsumption expenditures index excluding food and energy. Econmists expect that index rose 0.2% in April, and a 0.3% rise would likely fuel more June rate hike fears.
But the Fed economists suggest less of an emphasis on small variations in inflation numbers and more on the fundamental question of avoiding expectation traps.
"Credibility is not about getting the inflation rate right up to a tenth of a percent," Armenter and Bodenstein concluded. "It is about avoiding a 70s encore."
-By Brian Blackstone, Dow Jones Newswires; 202-828-3397; |
