This won't be for everyone, but I know many of you have an interest in issues involving inflation, money growth, and Federal Reserve policy so I thought I'd post (slightly shortened) remarks made by Ben Bernanke on the relationship between monetary policy, inflation, inflation expectations, and on how the Fed forecasts inflation.
It's a good, general summary (along with references) of where the literature stands on these topics. In looking for new parts in the speech, two things caught my attention. First, Bernanke's commitment to gradualism as a policy guideline. Under gradualism, the federal funds rate is adjusted slowly to a new target rather than jumping to a new target immediately. That is, if the Fed wants to raise interest rates by one percent, it can do so gradually, e.g. in four .25 percent moves, or it can jump the full amount in one move. Gradualism argues for the smaller, incremental moves of the type we have seen recently.
Bernanke has emphasized gradualism before (e.g. see this speech from 2004, "Gradualism"), but given a second emphasis in his speech, the use of models where learning by both the monetary authorities and the public plays a role, gradualism is worth emphasizing again because the imposition of learning generally enhances the gradualist case. His 2004 speech gives indications of what he means by a gradualism, he will advocate moving slowly to a new target except in very unusual circumstances, and the new learning results he's emphasizing will reinforce this approach to policy:
Inflation Expectations and Inflation Forecasting, by Chairman Ben S. Bernanke, Chairman, FRB: ...As you know, the control of inflation is central to good monetary policy. ... Inflation injects noise into the price system, makes long-term financial planning more complex, and interacts in perverse ways with imperfectly indexed tax and accounting rules. In the short-to-medium term, the maintenance of price stability helps avoid the pattern of stop-go monetary policies that were the source of much instability in output and employment in the past. More fundamentally, experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally, with potentially adverse effects on risk-taking, investment, and other productive activities that are sensitive to the public's assessments of the prospects for future economic stability. In the long term, low inflation promotes growth, efficiency, and stability--which, all else being equal, support maximum sustainable employment...
Admittedly, measuring the long-term relationship between growth or productivity and inflation is difficult. For example, it may be that low inflation has accompanied good economic performance in part because countries that maintain low inflation tend to pursue other sound economic policies as well. Still, I think we can agree that, at a minimum, the opposite proposition--that inflationary policies promote employment growth in the long run--has been entirely discredited and, indeed, that policies based on this proposition have led to very bad outcomes whenever they have been applied.
Inflation Expectations: Conceptual Frameworks
...How should we measure inflation expectations, and how should we use that information for forecasting and controlling inflation? I certainly do not have complete answers..., but I believe that they are of great practical importance. ...
What is the right conceptual framework for thinking about inflation expectations in the current context? The traditional rational-expectations model of inflation and inflation expectations has been a useful workhorse for thinking about issues of credibility and institutional design, but, to my mind, it is less helpful for thinking about economies in which (1) the structure of the economy is constantly evolving in ways that are imperfectly understood by both the public and policymakers and (2) the policymakers' objective function is not fully known by private agents. In particular, together with the assumption that the central bank's objective function is fixed and known to the public, the traditional rational-expectations approach implies that ... long-run inflation expectations do not vary over time in response to new information.
But in fact, ... long-run inflation expectations do vary over time. That is, they are not perfectly anchored in real economies; moreover, the extent to which they are anchored can change, depending on economic developments and (most important) the current and past conduct of monetary policy. In this context, I use the term "anchored" to mean relatively insensitive to incoming data. ...
Although variations in the extent to which inflation expectations are anchored are not easily handled in a traditional rational-expectations framework, they seem to fit quite naturally into the burgeoning literature on learning in macroeconomics. The premise of this literature is that people do not have full information about the economy or about the objectives of the central bank, but they instead must make statistical inferences about the unknown parameters governing the evolution of the economy. ...
Allowing for learning has important implications for how we think about the economy and policy. For example, some work has shown that the process of learning can affect the dynamics and even the potential stability of the economy... Considerations of how the public learns about the economy affect the form of optimal monetary policy... Notably, in a world with rational expectations and in which private agents are assumed already to understand all aspects of the economic environment, talking about the effects of central bank communication would not be sensible, whereas models with learning accommodate the analysis of communication-related issues quite well... Macroeconomic models with learning also give content to the idea of an economy moving gradually from one regime to another, particularly if the central bank as well as the public is assumed to be updating its beliefs. ... In sum, many of the most interesting issues in contemporary monetary theory require an analytical framework that involves learning by private agents and possibly the central bank as well.
Implications of Anchored Inflation Expectations
Why do we care about the variability of inflation expectations? As my colleague Rick Mishkin recently discussed, the extent to which inflation expectations are anchored has first-order implications for the performance of inflation and of the economy more generally... Mishkin illustrated this point by considering the implications of the fact that inflation expectations have become much better anchored over the past thirty years for the estimated coefficients of the conventional Phillips curve, which I define here to encompass specifications that use lagged values of inflation to proxy for expectations or other sources of inflation inertia. As he noted, many studies of the conventional Phillips curve find that the sensitivity of inflation to activity indicators is lower today than in the past (that is, the Phillips curve appears to have become flatter); and that the long-run effect on inflation of "supply shocks," such as changes in the price of oil, also appears to be lower than in the past... These findings are of much more than academic interest. To the extent that the Phillips curve may have flattened, inflation will now tend to be more stable than in the past in the face of variations in aggregate demand. (Of course, this can be a good thing or a bad thing, depending on whether inflation expectations are anchored in the vicinity of price stability.) Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.
Various factors might account for these changes in the Phillips curve, but, as Mishkin pointed out, better-anchored inflation expectations ... certainly play some role. If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity--that is, the conventional Phillips curve will be flatter.
Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent "wage-price spiral." With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices. A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on "core" inflation, that is, inflation excluding the prices of food and energy.
Although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored. A number of studies confirm that observation. ...
An indirect but elegant way to make the point that inflation expectations remain imperfectly anchored comes from a statistical analysis of inflation by Stock and Watson (2007). Stock and Watson model inflation as having two components, which may be interpreted as the trend and the cycle. Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary. The key finding of this research is that the variability of the trend component of inflation ... appears to have fallen significantly after about 1983. That is, unexpected changes in inflation are today much more likely to be transitory than they were before the early 1980s. ... I interpret the Stock-Watson finding as consistent with the view that inflation expectations have become much more anchored since the early 1980s. At the same time, that the variability of the trend component of inflation, though modest, ... implies that long-run expectations of inflation are not perfectly anchored today.
The policy implications of the much-improved but still imperfect anchoring of inflation expectations are not at all straightforward. ... With the hope of promoting progress on these broad topics, I pose three questions to researchers, the answer to any of which would be quite useful for practical policymaking.
First, how should the central bank best monitor the public's inflation expectations? Theoretical treatments tend to neglect the fact that in practice many measures of inflation expectations exist, including the forecasts of professional economists, results from surveys of consumers, information extracted from financial markets ..., and limited information on firms' pricing plans. ... On which measure or combination of measures should central bankers focus to assess inflation developments and the degree to which expectations are anchored? Do we need new measures of expectations or new surveys? Information on the price expectations of businesses--who are, after all, the price setters in the first instance--as well as information on nominal wage expectations is particularly scarce.
Second, how do changes in various measures of inflation expectations feed through to actual pricing behavior?...
Third, what factors affect the level of inflation expectations and the degree to which they are anchored? Answering this question essentially involves estimating the learning rule followed by the public or various components of the public... A fuller understanding of the public's learning rules would improve the central bank's capacity to assess its own credibility, to evaluate the implications of its policy decisions and communications strategy, and perhaps to forecast inflation. Realistically calibrated models with learning would also inform our thinking about policy and the economy.
Inflation Forecasting at the Federal Reserve
I would like to shift gears at this point to tell you a bit about how the Federal Reserve Board staff goes about forecasting inflation. ...[A]s I will discuss, the staff's long-term track record in forecasting inflation is quite good by any reasonable benchmark. ...
The Board staff employs a variety of formal models, both structural and purely statistical, in its forecasting efforts. However, the forecasts of inflation (and of other key macroeconomic variables) that are provided to the Federal Open Market Committee are developed through an eclectic process that combines model-based projections, anecdotal and other "extra-model" information, and professional judgment. In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science.
The forecasting procedures used depend importantly on the forecast horizon. For near-term inflation forecasting--say, for the current quarter and the next--the staff relies most heavily on a disaggregated, bottom-up approach that focuses on estimating and forecasting price behavior for the various categories of goods and services that make up the aggregate price index in question. For example, we know from historical experience that the prices of some types of goods and services tend to be quite volatile, including not only (as is well known) the prices of energy and some types of food but also some "core" prices such as airfares, apparel prices, and hotel rates. The monthly autocorrelations of price changes in these categories tend to be low or even negative. In contrast, changes in inflation rates in some services categories, such as shelter costs, tend to be more persistent. In assessing what price changes in a particular category imply for future price changes in that category, the staff uses not only various forms of time-series analysis but also specialized knowledge about how the various indexes are constructed--for example, whether certain categories are sampled every month in all localities and how seasonal adjustments are performed. In making very near-term price forecasts, the staff also uses diverse information from a variety of sources, such as surveys of prices of gasoline and other important items, news reports about price-change announcements, and anecdotal information from our business contacts. ...
Because inflation continues to exhibit some inertia, improved near-term forecasts translate into more-accurate longer-term projections as well.
For forecasting horizons beyond a quarter or two, detailed analyses of individual price components become less useful, and thus the staff's emphasis shifts to inflation's fundamental determinants. Food and energy inflation are forecasted separately from the core, using information from futures prices and other sources. However, forecasts of core inflation must take into account the extent to which food and energy costs are passed through to other prices.
To project core inflation at longer-term horizons, the staff consults a range of econometric models. Most of the models used are based on versions of the new Keynesian Phillips curve... Despite the common conceptual framework, the model specifications employed differ considerably in their details, including how lagged inflation enters the equation, how resource utilization is measured, and whether a survey-based measure of inflation expectations is included. In principle, formal econometric tests could determine how much weight should be put on the forecast of each model, but in practice the data do not permit sharp inferences; moreover, estimated forecasting equations may not reflect information about special factors affecting the outlook. Because of these considerations, as I have already noted, the staff's inflation forecasts inevitably reflect a substantial degree of expert judgment and the use of information not captured by the models. ...
[C]onsiderable progress has been made in recent years, at the Board and elsewhere, in developing dynamic stochastic general equilibrium (DSGE) models detailed enough for policy application. These models have become increasingly useful for policy analysis and for the simulation of alternative scenarios. They are likely to play a more significant role in the forecasting process over time as well, though, like other formal methods, they are unlikely to displace expert judgment.
A potential drawback of the simple Phillips curve model for analyzing and forecasting inflation is that it does not explicitly incorporate the possible influence of labor costs on the inflation process. The Board's large macroeconomic simulation model, known as FRB/US, projects inflation through a system approach that captures the interaction of wage and price determination. Interestingly, however, the system approach does not seem to forecast price inflation as well as single-equation Phillips curve models do. This weaker performance appears to reflect, at least in part, the shortcomings of the available data on labor compensation. ... Despite these problems, labor market developments certainly influence how the staff and policymakers view the inflation process and inflation risks, illustrating yet another point in the forecasting process at which judgment must play an important role. In particular, in evaluating labor-market conditions and trends in labor costs, the staff takes note of a wide range of data, anecdotes, and other qualitative information as well as the official data on compensation.
Overall, the Board staff's inflation forecasting has been remarkably good, at least compared with the available alternatives...
To link this discussion of forecasting to the first portion of my remarks, I turn to the treatment of inflation expectations in staff forecasts. As I noted earlier, while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks. A popular shortcut is to include lagged inflation terms in the Phillips curve equation; besides being a convenient means of capturing the inertial component in inflation, the estimated coefficients on lagged inflation almost certainly reflect to some degree the formation of inflation expectations and their influence on the inflation process. However, using lagged inflation as a proxy for inflation expectations has drawbacks, notably its susceptibility to the Lucas critique. The staff consequently analyzes a number of survey measures of inflation expectations. One question in choosing among measures of expectations is whether to focus on measures of short-term inflation expectations (say, twelve months ahead) or of longer-term expectations (five to ten years ahead). Generally, measures of longer-term inflation expectations, such as the five-to-ten-year expected inflation measures from the Michigan/Reuters survey of households and from the Survey of Professional Forecasters, seem to be better gauges of the expectations...
The staff also looks at measures derived from comparing yields on nominal and inflation-indexed Treasury securities (the breakeven inflation rate). Measures of inflation compensation derived from the market for inflation-indexed securities are influenced by changes in inflation risk premiums and liquidity premiums, and analyses are constrained by the fact that these markets have been operating in the United States for only a relatively short period. Nevertheless, unlike survey measures, breakeven inflation rates are determined in a market in which investors back their views with real money. Moreover, breakeven measures of inflation expectations provide information on the expectations of a different group of agents--financial-market participants--which can be compared with the views of economists and consumers as represented by surveys.
Measurement is only one aspect of understanding inflation expectations. We also need a better understanding of how inflation expectations affect actual inflation and of the factors that determine inflation expectations. ...
Recent staff work at the Board has analyzed the implications of expanding the set of variables allowed to influence the public's long-term inflation expectations to include, among others, the federal funds rate. If the public's long-term inflation expectations are influenced directly by Fed actions, as this specification suggests, a number of interesting implications follow. One is that the output costs of disinflation may be lower than those suggested by reduced-form-type Phillips curves. ... This ... is consistent with some analyses of the Volcker disinflation; although the costs of that disinflation were high, they were perhaps less than economists would have predicted in advance, given conventional estimates of the sacrifice ratio...
To be sure, this and similar analyses remain speculative. A good deal more must be done before such work proves a reliable basis for policy choices. Nevertheless, I hope this example illustrates for you the theme of my remarks, that a deeper understanding of the determinants and effects of the public's expectations of inflation could have significant practical payoffs.
Bernanke, Ben (2004). "Fedspeak," at the meetings of the American Economic Association, San Diego, California, January 3, 2004.
Bils, Mark and Peter Klenow (2004). "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, vol. 112 (October), pp. 847-85.
Bullard, James, and Kaushik Mitra (2002). "Learning about Monetary Policy Rules," Journal of Monetary Economics, vol. 49(September), pp. 1105-29.
Brayton, Flint, Eileen Mauskopf, David Reifschneider, Peter Tinsley, and John Williams (1997). "The Role of Expectations in the FRB/US Macroeconomic Model," Federal Reserve Bulletin, vol. 83(April), pp. 227-45.
Carroll, Christopher D. (2003). "Macroeconomic Expectations of Households and Professional Forecasters," Quarterly Journal of Economics, vol. 118 (February), pp. 269-98.
Cogley, Timothy (2005). "Changing Beliefs and the Term Structure of Interest Rates: Cross-Equation Restrictions with Drifting Parameters," Review of Economic Dynamics, vol. 8 (April), pp. 420-51.
Cogley, Timothy, and Thomas J. Sargent (2007). "Inflation Gap Persistence in the U.S. (5.7 MB PDF)" University of California, Davis, working paper, January.
Erceg, Christopher, and Andrew Levin (2003). "Imperfect Credibility and Inflation Persistence," Journal of Monetary Economics, vol. 50 (May), pp. 915-44.
Faust, Jon, and Jonathan H. Wright (2007). "Comparing Greenbook and Reduced Form Forecasts Using a Large Realtime Dataset (259 KB PDF)," Johns Hopkins University and Board of Governors, working paper.
Gaspar, Vitor, Frank Smets, and David Vestin (2006). "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, vol. 4 (April-May), pp. 376-85.
Gordon, Robert J. (2007). "Phillips Curve Specification and the Decline in U.S. Output and Inflation Volatility," presented at the Symposium on The Phillips Curve and the Natural Rate of Unemployment, Institut für Weltwirtschaft, Kiel, Germany, June 3-4.
Gürkaynak, Refet, Brian Sack, and Eric Swanson (2005). "The Sensitivity of Long-term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models," American Economic Review, vol. 95 (March), pp. 425-36.
Hooker, Mark (2002). "Are Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications versus Changes in Regime," Journal of Money, Credit, and Banking, vol. 34 (May), pp. 540-61.
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Levin, Andrew, Fabio Natalucci, and Jeremy Piger (2004). "The Macroeconomic Effects of Inflation Targeting (406 KB PDF)," Federal Reserve Bank of St. Louis, Review, vol. 86 (July), pp. 51-80.
Mankiw, N. Gregory, Ricardo Reis, and Justin Wolfers (2003). "Disagreement about Inflation Expectations," NBER Macroeconomics Annual, pp. 209-248.
Mishkin, Frederic S. (2007). "Inflation Dynamics," National Bureau of Economic Research Working Paper no. 13147, June.
Nakamura, Emi, and Jon Steinsson (2007). "Five Facts About Prices: A Reevaluation of Menu Cost Models (577 KB PDF)," Harvard University, working paper, May.
Nason, James (2006). "Instability in U.S. Inflation: 1967-2005," Federal Reserve Bank of Atlanta, Economic Review, vol. 91 (Second Quarter), pp. 39-59.
Orphanides, Athanasios, and John C. Williams (2005). "Inflation Scares and Forecast-based Monetary Policy," Review of Economic Dynamics, vol. 8 (April), pp. 498-527.
Roberts, John (2006). "Monetary Policy and Inflation Dynamics," International Journal of Central Banking, vol. 2 (September), pp. 193-230.
Romer, Christina, and David Romer (2000). "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, vol. 90 (June), pp. 429-57.
Rudebusch, Glenn, and Tao Wu (2003). "A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy (562 KB PDF)," Federal Reserve Bank of San Francisco Working Paper 2003-17, September.
Sargent, Thomas J. (1999). The Conquest of American Inflation. Princeton, N.J.: Princeton University Press.
Sims, Christopher (2002). "The Role of Models and Probabilities in the Monetary Policy Process," Brookings Papers on Economic Activity, vol. 2, pp. 1-40.
Stock, James, and Mark Watson (2007). "Why Has U.S. Inflation Become Harder to Forecast?" Journal of Money, Credit, and Banking, vol. 39 (February), pp. 3-34.
1. Roberts (2006) provides a recent overview. He attributes most of the "flattening" of the Phillips curve to changes in the conduct of monetary policy.See also Nason (2006). Gordon (2007) provides an opposing view.
2. Stock and Watson assume that transitory shocks last only one quarter. Cogley and Sargent (2007) explore the Stock-Watson specification in more detail, arguing that the transitory component of inflation is best modeled as having somewhat greater persistence.
3. A particularly valuable part of the paper is a case study of the evolution of expectations during the Volcker disinflation of 1979-1982. Histograms of the quarterly range of inflation expectations show only a very gradual adjustment of inflation expectations as the disinflation proceeded, with significant reductions in expectations occurring only in the third year of the disinflation. Moreover, the range of disagreement widened (and even became somewhat bimodal) as individual respondents evidently differed in their willingness to accept the Fed"s declared commitment to reducing inflation as being a true break from the past. Capturing this behavior in a formal model would be challenging but worthwhile.
4. The Lucas critique holds that reduced-form empirical relationships estimated on historical data may break down when policies change.
5. In this empirical work, the public"s long-run inflation expectations are proxied for by the long-run inflation projections taken from the Survey of Professional Forecasters (Mishkin, 2007).