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Thursday, December 13, 2012

The Fed and Long-Run Expectations

Paul Krugman on the Fed:

Bernanke’s Non-Stupidity Pact: So, how big a deal was yesterday’s Fed announcement? Philosophically, it was pretty major; in terms of substantive policy implications, not so much.
What the Fed did was pledge not to raise rates until unemployment is considerably lower than it is now, or inflation is running significantly above the 2 percent target. One fairly important wrinkle I haven’t seen emphasized: the inflation criterion was couched in terms of the inflation projection, rather than past inflation. This would let the Fed hold rates low even in the face of a blip caused by, say, a sharp rise in commodity prices.
It’s fairly clear — although not explicitly stated — that the goal of this pronouncement is to boost the economy right now through expectations of higher inflation and stronger employment than one might otherwise have expected. ...

What do we know about the expectations channel? Larry Ball via Greg Mankiw:

Interpreting the Fed: My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:

I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dictates. ...

This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. ...

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

There are two expectations channels here. One is expected inflation (the traditional channel), the other is "stronger employment than one might otherwise have expected" due to interest rates staying lower for a longer period of time than might have otherwise been expected (this is the channel that many at the Fed are relying upon). We have little evidence on this latter channel. As for the traditional channel, it may be difficult to move inflation expectations now that they "are almost perfectly anchored" (there is much more background and explanation in the article):

Inflation Expectations Have Become More Anchored Over Time, Economic Letter, by J. Scott Davis, FRB Dallas: The Organization of Arab Petroleum Exporting Countries imposed an oil embargo on the United States in October 1973 in response to U.S. support of Israel during the Yom Kippur War. The embargo was lifted in March 1974, and although it lasted less than six months, the effects on inflation and inflation expectations in the United States would persist for a decade.
Oil prices spiked, increasing by more than 350 percent from June 1973 to June 1974, propelling a sharp increase in U.S. inflation (Chart 1). Consumer prices jumped 12 percent in 1974, from a 3 percent rise in 1972. Although the 1973 oil price shock was transitory—the price of oil declined over the next two years—inflation proved more persistent. After exceeding 5 percent in 1973, it didn’t fall below that level again until 1982.
The experiences of the 1970s show that when inflation expectations become unanchored, they may become self-fulfilling, or in the words of former Federal Reserve Chairman Paul Volcker, “inflation feeds in part on itself.” This helps explain how a transitory oil price spike in 1973—along with a second oil shock in the late 1970s (associated with the 1979 Iranian Revolution)—could lead to a decade of high inflation. Over the past 30 years, Federal Reserve policy has succeeded in better anchoring inflation expectations, producing diminished expectations that a short-term shock leads to sustained high inflation. ...
Measuring Inflation Anchoring
One way to gauge such anchoring is calculating the responsiveness of expected inflation in the next few years to a shock to current inflation. If expectations are well-anchored, the response will be minimal. ...
A plot of the changes in the five-year-ahead, five-year-forward expected inflation rate shows that during the early part of the 1983–2011 period, long-run inflation expectations were quite variable and highly correlated with unexpected inflation (Chart 3). For instance, in early 1984, when inflation turned out to be almost 1 percentage point higher than expected, the expectation of long-run inflation also increased by nearly 1 percentage point. A few years later, in 1986, when inflation turned out to be 3 percentage points lower than expected, people reduced their expectations of long-run inflation by 1 percentage point.
The chart shows that over this nearly 30-year sample, long-run inflation expectations became less volatile and less responsive to surprises in current inflation. For example, between 2008 and 2011, unexpected inflation fluctuated: 3 percent in 2008, negative 5 percent in 2009, 3 percent in early 2010, negative 2 percent later in 2010 and 3 percent in 2011—yet, long-run inflation expectations over this period, as measured by revisions in the five-year-ahead, five-year-forward rate, barely moved.
The statistical methodology of ordinary least-squares regression allows analysis of the relationship between two or more variables. This “averaging” tool helps measure how short-run surprises affect long-term inflation expectations. For example, if inflation over the past year is 1 percentage point higher than expected, the least-squares regression results show that people tend to raise their long-run expectations by some number γ of percentage points—for 1983–2011, γ is 0.11 (Table 1). This means that, on average over the period 1983 to 2011, a 1 percentage point surprise in the inflation rate raised long-term inflation expectations by 0.11 percentage points. The smaller the value of γ, the more anchored are long-run inflation expectations—if γ is not significantly different from zero, then long-run expectations are perfectly anchored.


Anchoring of inflation expectations over the past 30 years has changed markedly, as shown by the results in the bottom half of Table 1. In the 1980s, confronted with a 1 percentage point higher-than-anticipated inflation rate, people boosted their expectations for long-run inflation by 0.28 percentage points. However, since 2000, people raise their expectations by about 0.03 percentage points following a similar surprise, suggesting that long-run expectations are almost perfectly anchored.
As few as 30 years ago, long-run inflation expectations were quite responsive to short-term shocks. Over the ensuing period, the Fed has been better able to anchor such expectations so that now long-run expectations barely change following a series of dramatic, but ultimately transitory, inflation surprises. ...

    Posted by on Thursday, December 13, 2012 at 10:42 AM in Economics, Inflation, Monetary Policy, Unemployment | Permalink  Comments (27)



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