(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link).
I am often critical of central banks these days, and especially the Federal Reserve. But that doesn’t mean I think the entire institution is worthless. While quite often the staff at the Fed puts out papers that use convoluted and inscrutable mathematics to “prove” something that only works because the assumptions used are garbage, there are also occasionally good bits of work that come out. While it is uneven, I find that the Atlanta Fed’s “macroblog” often has good content, and occasionally has a terrific insight.
The latest macroblog post may fall into the latter category. Before I talk about the post, however, let me as usual admonish readers to remember that wages follow inflation; they do not lead or cause inflation. That reminder is very important to keep in mind, along with the realization that some policymakers do think that wages lead inflation and so don’t get worried about inflation until wages rise as well.
With that said, John Robertson and Ellyn Terry at the Atlanta Fed published this great macroblog article in which they present the Atlanta Fed’s Wage Growth Tracker. Here’s the summary of what they say: most wage surveys have significant composition effects, since the group of people whose wages you are surveying now are very different from the group you surveyed last year. Thus, measures like Average Hourly Wages from the Employment report (which has been rising, but not alarmingly so) are very noisy and moreover might miss important trends because, say, high-wage people are retiring and being replaced by low-wage people (or industries).
But the Atlanta Fed’s Wage Growth Tracker estimates the wage growth of the same worker’s wage versus a year ago. That is, they avoid the composition effect.
It turns out that the Wage Growth Tracker has been rising much more steadily and at a higher rate than average hourly earnings. Here is the drop-the-mic chart:
With this data, the Phillips curve works like a charm. Higher employment is not only related, but closely related to higher wage growth. (For the record, Phillips never said that broad inflation was related to the unemployment rate. He said wage inflation was. See my post on the topic here.) The good news is that this doesn’t really say anything about future inflation, and what it means is that the worker who is actually employed right now is still keeping pace with inflation (barely) thanks to relatively strong employment dynamics.
The bad news, for Yellen and the other doves on the FOMC, is that if they were hiding behind the “tepid wage growth” argument as a reason to be suspicious that inflation will not be maintained, the Atlanta Fed just took a weed-whacker to their argument.
(**Administrative Note: Get your copy of my new book What’s Wrong with Money: The Biggest Bubble of All! Here is the Amazon link.)
Last week, one of the curious parts of the CPI report was the large jump (1.6% month/month, or nearly 20% annualized) in Apparel. At the time, I dismissed this rise with a hand-wave, pointing out that it Apparel is only 4% of core and so I don’t worry as much about Apparel as I do, say, Medical Care or Housing.
But a Twitter follower called to my attention the words of @IanShepherdson, one of the real quality economists out there (and one whom I read regularly when he was with High Frequency Economics, and I was at Natixis). He hasn’t always been on top of the inflation story, but he nailed the housing bubble story in 2008 and I have great respect for him. Ian apparently said of Apparel that it could be the proverbial “canary in the coal mine” when it comes to inflation, since apparel tends to respond more quickly to inflationary pressures since it is a very competitive and very homogeneous category.
So I figured it was worth taking a longer look at inflation.
Now, I should point out that I probably have a bias about getting over-excited about inflation. Back in 2011-12, Apparel prices started to accelerate rapidly for the first time in a generation- and that’s no hyperbole. As the chart below (Source: Bloomberg) shows, the price index for seasonally-adjusted apparel prices went sideways-to-down-to-sideways between 1992 and 2012.
You can see from this why I may have gotten excited in 2012. Between 1970 and 1992, apparel prices rose at a very steady rate. Then, as post-Cold War globalization kicked into high gear, apparel manufacture moved from being largely produced in the US to being largely produced outside of the US; the effect on prices is apparent on the chart. But in 2011-2012, the price index began to move higher at almost the same slope as it had been moving prior to the globalization dividend. My thought back then was that the dividend only happens once: at first, input costs are stable or declining because high-cost US labor is replaced with low-cost overseas labor – but eventually, once all apparel is produced overseas, then the composition effect is exhausted and input prices will rise with the cost of labor again. In 2012, I thought that might be happening.
And then Apparel flattened out.
You can see, though, from the right side of the chart the latest spike that has Ian (and maybe me) so excited. The month/month rise was the third largest in the last 30 years, exceeded only by February 2009 and February 2000. As an aside, the fact that the three largest monthly spikes were all in February ought to make you at least a little suspicious that some of what is going on may be a seasonal-adjustment issue, but let’s leave that aside for now because I’m rolling.
What about the assertion that Apparel may be the ‘canary in the coal mine,’ giving an early indication on inflation? The chart below (source: Bloomberg, and Enduring Investments calculations) shows the year-over-year change in Apparel prices (on the right-hand scale) versus core CPI (on the left-hand scale).
I do have to admit, there is something suggestive about that chart although it is at least somewhat visual since I can’t find a consistent lag structure in the data. But the clear turns do seem to happen first in Apparel, often. Ah, but here is the fun chart. For the next chart, I’ve also taken out Shelter from core inflation, since Shelter especially in recent years has been largely driven by pretty crazy monetary policy, as I have pointed out before many times. (And if you want to read what I think that’s likely to lead to, read my book.) To make it fair, I also removed Apparel itself since once Shelter and Food and Energy are all removed, Apparel is starting to matter.
In this chart, you can start to see a pretty interesting tendency for Apparel to perhaps lead, slightly – and so, perhaps, Ian is right. In this case, I certainly wouldn’t want to bet against him since I think that’s where inflation is going too. I just wasn’t sure that Apparel was a strong part of the argument. (But at the same time, notice the big spike in Apparel inflation in 2012 preceded a rise in ex-housing core, but not a large or sustained rise in ex-housing core).
The table below shows the breakdown of Apparel into its constituent parts. The first column is the category, the second column is the weight (in overall CPI), the third column is the current y/y change, and the fourth column is the previous y/y change.
|Category||Weights||y/y change||prev y/y change|
|Boys’ and girls’ footwear||0.17%||2.506%||-0.046%|
I look at this to see whether there’s just one category that is having an outsized move; if there were, then we would worry more about one-off effects (say, the rollout of a new kind of women’s blouse that is suddenly all the rage). It is interesting that Men’s apparel and Boys’ apparel decelerated, while most everything else accelerated, but this happens all the time in the Apparel category. Actually, this is a pretty balanced set of sub-indices, for Apparel.
Now, I’m still not 100% sure this isn’t a seasonal-adjustment issue. It could be related to weather, or day count (29 days in February!), or some bottleneck at a port that caused a temporary blip in prices. I want to see a few more months before getting excited like I did in 2012! But we have had a couple of bad core CPI prints, and we also saw pressure in Medical Care so it is fair to say the number of alarm bells has broadened from one (Housing) to several (Housing, Medical Care, Apparel). It is fair to be concerned about price pressures at this point.
Today’s news was the Employment number. I am not going to talk a lot about the number, since the January jobs number is one of those releases where the seasonal adjustments totally swamp the actual data, and so it has even wider-than-normal error bars. I will discuss error bars more in a moment, but first here is something I do want to point out about the Employment figure. Average Hourly Earnings are now clearly rising. The latest year-on-year number was 2.5%, well above consensus estimates, and last month’s release was revised to 2.7%. So now, the chart of wage growth looks like this.
Of course, I always point out that wages follow inflation, rather than leading it, but since so many people obsess about the wrong inflation metric this may not be readily apparent. But here is Average Hourly Earnings, y/y, versus Median CPI. I have shown this chart before.
The salient point is that whether you are looking at core CPI or PCE or Median CPI, and whether you think wages lead prices or follow prices, this number significantly increases the odds that the Fed raises rates again. Yes, there are lots of reasons the Fed’s intended multi-year tightening campaign is unlikely to unfold, and I am one of those who think that they may already be regretting the first one. But a number like this will tend to convince the hawks among them otherwise.
Speaking of the Fed, last night I attended a speech by Cleveland Fed President Loretta Mester, sponsored by Market News International. Every time I hear a Fed speaker speak, afterwards I want to put my head into a vise to squeeze all of the nonsense out – and last night was no different. Now, Dr. Mester is a classically-trained, highly-accomplished economist with a Ph.D. from Princeton, but I don’t hold that against her. Indeed, credit where credit is due: unlike many such speakers I have heard in the past, Dr. Mester seemed to put more error bars around some of her answers and, in one of the best exchanges, she observed that we won’t really know whether the QE tool is worth keeping in the toolkit until after monetary conditions have returned to normal. That’s unusual; most Fed speakers have long been declaring victory. She is certainly a fan and an advocate of QE, but at least recognizes that the chapter on QE cannot yet be written (although I make what I think is a fair attempt at such a chapter in my book, due out in a month or so).
But the problem with the Federal Reserve boils down to two things. First, like any large institution there is massive groupthink going on. There is little true and significant diversity of opinion. For example there are, for all intents and purposes, no true monetarists left at the Fed who have any voice. Daniel Thornton at the St. Louis Fed was the last one who ever published pieces expressing the important role of money in monetary policy, and he retired a little while back. As another example, it is taken as a given that “transparency” is a good thing, despite the fact that many of the questions posed last night to Dr. Mester boiled down to problems that are actually due to too much transparency. I doubt seriously whether there has ever been a formal discussion, internally, of the connection between increased financial leverage and increased Fed transparency. Many of the problems with “too big to fail” institutions boil down to too much leverage, and a transparent Fed that carefully telegraphs its intentions will tend to increase investor confidence in outcomes and, hence, tend to increase leverage. But I cannot imagine that anyone at the Fed has ever seriously raised the question whether they should be giving less, rather than more, information to the market. It is significantly outside of chapter-and-verse.
The second problem is that the denizens of the Fed overestimate their knowledge and their ability to know certain things that may simply not be knowable. Again, Dr. Mester was a mild exception to this – but very mild. When someone says “We think the overnight rate should normalize more slowly than implied by the Taylor Rule,” but then doesn’t follow that up with an explanation of why you think so, I grow wary. Because economics in the real world, practiced honestly, should produce a lot of “I don’t know” answers. It may be boring, but this is how the question-and-answer with Dr. Mester should have gone:
Q: What do you think inflation will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think short rates will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think the Unemployment Rate will do in 2016?
A: I don’t know. I can tell you my point estimate, but it has really wide error bars.
Q: What do you think the Unemployment Rate will do in 2017?
A: I don’t know. I can tell you my point estimate, but it has really, really wide error bars.
Q: What do you think the consensus is at the Fed about the optimal pace of raising rates?
A: I don’t know. Each person on the Committee has a point estimate, each of which has really wide error bars. Collectively, we have an average that has even wider error bars. We cannot therefore usefully characterize what the path of the short rate will look like. At all.
Indeed, this is part of the problem with transparency. If you are going to be transparent, there is going to be pressure to provide “answers.” But a forecast without an error bar is just a guess. The error bars are what cause a guess to become an estimate. So we get a “dot plot” with a bunch of guesses on it. The actual dot plot, from December, looks like this:
But the dot plot should look more like this, where the error bars are all included.
Obviously, we would take the latter chart as meaning…correctly…that the Fed really has very little idea of where the funds rate is going to be in a couple of years and cannot convincingly reject the hypothesis that rates will be basically unchanged from here. That’s simultaneously transparent, and very informational, and colossally unhelpful to fast-twitch traders.
And now I can release the vise on my head. Thank you for letting me get the nonsense out.
The news on Friday that the Bank of Japan had joined the ECB in pushing policy rates negative was absorbed with brilliant enthusiasm on Wall Street. At least, much of the attribution for the exceptional rally was given to the BoJ’s move. I find it implausible, arguably silly, to think that a marginal change in monetary policy by a desperate central bank on the other side of the world – however unexpected – would have a massive effect on US stocks. Subsequent trading, which has reversed almost all of that ebullience in two days, suggests that other investors also may agree that just maybe the sorry state of earnings growth rates in this country, combined with a poor economic outlook and still-lofty valuations, should matter more than Kuroda’s gambit.
To be sure, this is a refrain that Ben Bernanke (remember him? Of helicopter infamy?) was singing last month, before the Federal Reserve hiked rates impotently, and clearly the Fed is investigating whether negative rates is a “tool” they should add to their oh-so-expansive toolbox for fighting deflation.
Scratch that. The Fed no longer needs to fight deflation; inflation is at 2.4% and rising. The toolbox the Fed is interested in adding to is the one that contains the tools for goosing growth. That toolbox, judging from historical success rates, is virtually empty. And always has been.
Back to Japan: let me point out that if the BOJ goal has been to extinguish deflation, it has already done so. The chart below (source: Bloomberg) shows core inflation in Japan for the last 20 years or so. Abstracting from the sales-tax-related spike, core inflation has risen fairly steadily from -1.5% to near 1.0% since mid-2010.
They did this, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015 (see chart, source: Bloomberg).
Not rocket science, folks. Monetary science.
Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that and wants to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was exactly the wrong thing to do. The regression below (source: Bloomberg) illustrates in a different way what I have shown here before: interest rates and money velocity are closely tied (as Friedman explained decades ago). The r-squared of this relationship – assuming that functionally a linear fit is appropriate, which I am not sure of – is a heady 0.822.
You may notice the data is from the US; that’s because Bloomberg doesn’t have a good velocity series for Japan’s M2 but the causal relationship is the same: lower term interest rates imply less reason not to hold cash.
Now, it may be the case that this relationship ceases to apply at negative rates even though the idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as if investment opportunities suddenly appeared. And rates, not just overnight but term rates, just went negative in Japan. The chart below (source: Bloomberg) shows the 5y JGB rate.
- The speculation that sub-zero rates might cause a rise in velocity is just that: speculation. There’s no data to suggest that this effect exists.
- Frankly, I suspect it doesn’t, but it’s possible. However, if it does I would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.
- If it does exist, it still doesn’t mean that cutting rates to a negative rate was wise. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same. Lots more.
- More likely, the BoJ is doing this because they believe that negative rates will stimulate growth. This is much more speculative than you might think, and I may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.
- Whatever the point of the BoJ’s move, the size of any growth effect from currency reactions is utterly dependent on the reaction function of trading counterparties. If other countries seek to devalue their currencies as well, then the whole operation will be inert.
So, will the BoJ’s move save US stocks? Heck, it won’t even save the Japanese economy.
Economics is too important to be left to economists, apparently.
When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!
Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.
A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.
It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.
Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”
In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”
Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.
Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:
- Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
- As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
- Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.
Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.
And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.
Some days make me feel so old. Actually, most days make me feel old, come to think of it; but some days make me feel old and wise. Yes, that’s it.
It is a good time to remember that there are a whole lot of people in the market today, many of them managing many millions or even billions of dollars, who have never seen a tightening cycle from the Federal Reserve. The last one began in 2004.
There are many more, managing many more dollars, who have only seen that one cycle, but not two; the previous tightening cycle began in 1999.
This is more than passing relevant. The people who have seen no tightening cycle at all might be inclined to believe the hooey that tightening is bullish for stocks because it means a return to normalcy. The people who have seen only one tightening cycle saw the one that coincided with stocks’ 35% rally from 2004-2007. That latter group absolutely believes the hooey. The fact that said equity market rally began with stocks 27% below the prior all-time high, rather than 32% above it as the market currently is, may not have entered into their calculations.
On the other hand, the people who dimly recall the 1999 episode might recall that the market was fine for a little while, but it didn’t end well. And you don’t know too many dinosaurs who remember the abortive tightening in 1997 in front of the Asian Contagion and the 1994 tightening cycle that ended shortly after the Tequila crisis.
Moreover, it is a good time to remember that no one in the market today, or ever, can remember the last time the Fed tightened in an “environment of abundant liquidity,” which is what they call it when there are too many reserves to actually restrain reserves to change interest rates. That’s because it has never happened before. So if anyone tells you they know with absolute certainty what is going to happen, to stocks or bonds or the dollar or commodities or the economy or inflation or anything else – they are relying on astrology.
Many of us have opinions, and some more well-informed than others. My own opinion tends to be focused on inflationary dynamics, and I remain very confident that inflation is going to head higher not despite the Fed’s action today, but because of it. I want to keep this article short because I know you have a lot to read today, but I will show you a very important picture (source: Bloomberg) that you should remember.
The white line is the Federal Funds target rate (although that meant less at certain times in the past, when the rate was either not targeted directly, as in the early 1980s, or the target was represented as a range of values). The yellow line is core inflation. Focus on the tightening cycles: in the early 1970s, in the late 1970s, in 1983-84, in the late 1980s, in the early 1990s, in 1999-2000, and the one beginning in 2004. In every one of those episodes, save the one in 1994, core inflation either began to rise or accelerated, after the Fed began to tighten.
The generous interpretation of this fact would be that the Fed peered into the future and divined that inflation was about to rise, and so moved in spectacularly-accurate anticipation of that fact. But we know that the Fed’s forecasting abilities are pretty poor. Even the Fed admits their forecasting abilities are pretty poor. And, as it turns out, this phenomenon has a name. Economists call it the “price puzzle.”
If you have been reading my columns, you know this is no puzzle at all for a monetarist. Inflation rises when the Fed begins to tighten because higher interest rates bring about higher monetary velocity, because velocity is the inverse of the demand for real cash balances. That is, when interest rates rise you are less likely to leave money sitting idle; therefore, investors and savers play a game of monetary ‘hot potato’ which gets more intense the higher interest rates go – and that means higher monetary velocity. This effect happens almost instantly. After a time, if the Fed has raised rates in the traditional fashion by reducing the growth rate of money and reserves, the slower monetary growth rate comes to dominate the velocity effect and inflation ebbs. But this takes time.
And, moreover, as I have pointed out before and will keep pointing out as the Fed tightens: in this case, the Fed is not doing anything to slow the growth rate of money, because to do that they would have to drain reserves and they don’t know how to do that. I expect money growth to remain at its current level, or perhaps even to rise as higher interest rates provoke more bank lending without and offsetting restraint coming from bank reserve scarcity. By moving interest rates by diktat, the Fed is increasing monetary velocity and doing nothing (at least, nothing predictable) with the growth rate of money itself. This is a bad idea.
No one knows how it will turn out, least of all the Fed. But if market multiples have anything to do with certainty and low volatility – then we might expect lower market multiples to come.
I think it is time to talk a little bit about “anchored inflation expectations.”
Key to a lot of the inflation modeling at the Fed, and in some sterile economics classrooms around the country, is the notion that inflation is partially shaped by the expectations of inflation. Therefore, when people expect inflation to remain down, it tends to remain down. Thus, you often hear Fed officials talk about the importance of inflation expectations being anchored, and that phrase appears often in Federal Reserve statements and minutes.
I have long found it interesting that with as much as the Fed relies on the notion that inflation expectations are anchored, they have no way to accurately measure inflation expectations. Former Fed Chairman Bernanke said in a speech in 2007 that three important questions remain to be addressed about inflation expectations:
- How should the central bank best monitor the public’s inflation expectations?
- How do changes in various measures of inflation expectations feed through to actual pricing behavior?
- What factors affect the level of inflation expectations and the degree to which they are anchored?
According to Bernanke, the staff at the Federal Reserve struggle with even the first of these questions (“while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks”), although this has not deterred them from tackling the second and third questions. Economists use the Hoey survey, the Survey of Professional Forecasters, the Livingston survey, the Michigan survey, and inflation breakevens derived from the TIPS or inflation swaps markets. But all of these suffer from the fundamental problem that what constitutes “inflation” is a difficult question in itself and answering a question about a phenomenon that is hard to quantify viscerally probably causes people to respond to surveys with an answer indicating what they expect the well-known CPI measure to show. I talked about many of these problems in my paper on measuring inflation expectations (“Real-Feel” Inflation: Quantitative Estimation of Inflation Perceptions), but the upshot is that we don’t have a good way to measure expectations.
So, with that as background, consider this fact: next year, some Medicare participants will face a 0% increase in premiums while some Medicare participants will face increases of more than 50%.
I am skeptical of the notion of inflation anchoring. But I am really skeptical if it is the case that different segments of the population see totally different inflation pictures. Which anchor counts, if one large group of people expects 7% inflation and another large group expects 1% inflation?
I would argue that none of those anchors matter, because the whole notion is silly. Let’s think through the mechanism of “inflation anchoring.” So the idea is that when people expect lower inflation, they make decisions that tend to produce lower inflation. What decisions are those? If you expect 1% inflation, but Medicare costs go up 50%, what decision are you going to make that will cause that increase to be closer to your expectations? If eggs go up 25 cents per carton and you were expecting 5 cents…is the idea that no one will buy eggs and so the vendor will have to lower the price? What about his costs? Pretty clearly, the mechanism will have to work on the seller’s side, but since every seller is a buyer except for the original seller of labor, the idea must be that if people expect high inflation they argue for higher wages, which causes prices to rise.
I have put paid to that notion in this space before. It doesn’t make any sense to think that wages lead inflation, for if they did then we would all love inflation because we would always be ahead of it. But we know that’s not how it works – prices rise, and then we get higher wages. And sometimes we don’t.
Let’s try another hypothetical. Suppose the Federal Reserve literally drops $50 trillion, unexpectedly, from helicopters. And suppose that consumers did not change their expectations for inflation because they believed, much like the Fed does, that money doesn’t play a role in causing inflation – in other words, their expectations were “extremely well-anchored.” Does anyone think that the price level wouldn’t change, a lot, in contrast to the expectations of the crowd? (I sometimes wonder if Lewis Carroll’s Red Queen, who “sometimes…believed as many as six impossible things before breakfast,” was a Fed economist.)
The whole idea that inflation expectations matter is an effort to explain why parameterizations of inflation models have a regime break in the early 1990s. That is, you can fit a model to 1970-1992, or to 1994-present, but you need different parameters for almost anything you try in the Keynesian-modeling world. Econometricians know that outcome means that you are missing an explanatory variable somewhere; econometricians also know that a very convenient way to gloss over the problem is to introduce a “dummy” variable. In this case, the dummy variable is explained as “inflation expectations became anchored in the early 1990s.”
With all of the problems affecting the notion of expectations-anchoring, I find this solution to the modeling problem deeply unsatisfying. I do not believe that inflation expectations anchor for everybody collectively, but that different groups of people have different (and widely different) anchors. And I don’t think that these anchors themselves play much of a role at all in causing a certain level of inflation. There are better models, simpler models, which do not require you to believe six impossible things.
Unfortunately, they do require you to believe in monetarism. And to some people, that is a seventh impossible thing.