Jeffrey Lacker: The Inflation Outlook

Jeffrey Lacker discusses the outlook for inflation. He does not appear as convinced as some of the other committee members that slowing output growth by itself will cause inflation to moderate. Instead it will depend upon the ability of policymakers to influence and bring down inflation expectations. Along the way, he also hints at the Fed's numerical target range for inflation:

The Inflation Outlook, by Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond: I am pleased to be with you tonight to discuss my views on the outlook for inflation.[1] In its most recent statements, the Federal Open Market Committee has identified "the risk that inflation will fail to moderate as expected" as its "predominant policy concern." This places current inflation and the inflation outlook squarely at center stage in thinking about the economy and monetary policy. So in my remarks..., I will take a closer look at inflation's recent behavior and the prospects for its future behavior. ...

Recent Inflation ...In early 2003, inflation fell, and for some months inflation was reported to be below 1 percent at an annual rate.[3] This led to concern about the possibility of excessive disinflation, and in response, the FOMC statement at the May meeting cited the risk of "an unwelcome substantial fall in inflation," and at the June 2003 meeting, the FOMC reduced the target federal funds rate to 1 percent. While the Committee had not then, and has not since, established an explicit numerical target range for inflation, the May 2003 statement was taken to many observers as establishing an implicit lower bound on the range of inflation rates the Committee would find acceptable.[4]

Core inflation has increased since 2003. From a low of 1.3 percent for the 12 months ending in September 2003, it rose to more than 2 percent in April 2004, and has fluctuated between 2 percent and 2.4 percent ever since. ...[I]t is difficult to pick out a definite trend, and in fact, no statistically significant moderating trend has emerged yet, an issue I will return to later in my talk. About all one can say with confidence is that core inflation is now fluctuating around 2¼ percent.

Chairman Ben Bernanke, in his March 28 testimony to the Joint Economic Committee, said about core inflation that "recent readings have been somewhat elevated and the level of core inflation remains uncomfortably high." In addition, I and several other FOMC participants have expressed dissatisfaction with the current level of inflation. Even though, as I noted earlier, the Committee has not established an explicit numerical objective or range for inflation, some observers have taken recent comments as indicating an upper bound on the range of desired inflation rates, analogous to the way the Committee's May 2003 statement was taken as marking a lower bound.

The central question, then, regarding the outlook for inflation is whether core inflation will "moderate" to an acceptable rate in coming quarters. Some forecasters are expecting inflation to decline this year and next, and many of them link this decline to the expectation that real growth has been weak and is expected to remain below trend over the next few quarters. The relationship between real activity and the inflation outlook, which I will discuss in more detail later on, is important enough to warrant a look at selected components of final demand.

Real Activity ... Putting this all together, I expect overall growth to come in below trend in the first half of this year, but to return to trend by the end of the year, based on my expectation that the housing market is likely to find a bottom some time this year and no longer be a drag on top line growth, business investment will pick up, and consumer spending will remain healthy.

The Phillips Curve As I mentioned earlier, many commentators base their belief that inflation will moderate on their belief that output growth will be below trend for the next few quarters. This connection is based on a popular – though I will argue incomplete and potentially misleading – understanding of the relationship between inflation and real economic activity. This relationship is usually described by the "Phillips curve," which typically shows an inverse relationship between inflation and unemployment or the "output gap."[7]...

Modern monetary economics now understands the relationship between inflation and real activity as resulting from the decentralized price- and wage-setting decisions of firms and workers facing frictions that make very frequent price re-adjustments suboptimal. Firms set prices based on their expectations regarding the marginal cost of production and the rate at which overall nominal demand will change over their planning horizon. Aggregating across sellers, one finds that the current overall price level, and thus current inflation, depends on expected future inflation and real marginal cost. Under certain assumptions, real marginal cost moves one-for-one with a measure of aggregate economic activity such as the output gap or the unemployment rate.[8]

The result is a version of the Phillips curve in which current inflation depends on expected future inflation and an indicator of current economic activity, such as unemployment or the "output gap." But to state it this way – with inflation depending on a real variable – is entirely arbitrary. One could just as well write the relationship the other way and say that unemployment, for example, depends on inflation and expected inflation. In fact, inflation and real economic activity are the joint outcome of decentralized decisions made by participants in the economy about demand, supply, prices and wages. So it is just as correct (or rather incorrect) to say below-trend growth will drive inflation down, as it is to say that falling inflation will keep growth below trend. Because inflation ultimately depends on the actions of the central bank, those decentralized decisions will depend on past, present and expected future central bank policy choices. Thus, it is central banks, not the labor market, that drive inflation down.

The behavior of inflation expectations is vitally important to a central bank that is attempting to reduce inflation. ...

Inflation expectations embody assumptions – either explicit or implicit – about how the central bank is going to conduct monetary policy in the future. One possibility is that expectations are the result of past experience – that people simply extrapolate the recent behavior of inflation into the future. Statistically, this approach to expectations may work reasonably well for people most of the time, especially if the fundamental behavior of the central bank is not changing much. People taking this approach would tend to not adjust their expectations for future inflation until they saw movements in actual inflation. In this case, a successful disinflation that brings down both actual and expected inflation could be protracted and costly. ...

Alternatively, people may take a more forward-looking approach. They may believe that current inflation has deviated temporarily from its long-run trend, and so they may discount recent observations. Moreover, they take into account that inflation will behave differently in the future if the behavior of the central bank changes. This is likely to be particularly important if the central bank communicates convincingly its intention to behave differently. For example, in many countries inflation expectations seemed to shift when the central bank adopted inflation targeting. Public understanding of the central bank's long-run goals and of how the central bank would respond to various potential economic disturbances helps anchor inflation expectations. ...

Outlook A variety of expectations measures ... point to expectations for core PCE inflation of about 2 percent right now. What does this imply about the outlook for actual inflation, which is now running at about 2¼ percent? The current level of inflation expectations is likely to exert a gravitational pull on actual inflation, if monetary policy actions are not inconsistent with those expectations and no concerted effort is made to shift expectations. Policy actions at variance with those expectations – for example, significant easing at a time of elevated or rising inflation – would likely call those expectations into question and lead to a change in assessments regarding future inflation. But as long as policy actions appear to be plausibly consistent with movement toward 2 percent inflation and nothing else acts to alter inflation expectations, that's likely to be the best forecast of where inflation is headed.

Could inflation fall below 2 percent, say to 1½ percent? That depends. Without a prompt fall in inflation expectations, a reduction in inflation below 2 percent is likely to be temporary and hard to sustain. ...

The prospects for bringing inflation down below 2 percent thus hinge on the extent to which a reduction in inflation expectations can be brought about. How difficult would that be? Using changes in the target interest rate alone, the process is likely to be difficult and time-consuming. Costly reductions in real incomes and employment would be required until inflation expectations adapt. ...

One natural approach to bringing inflation expectations down more expeditiously, should that be the desire, would be a strategy of clear communications about policymakers' intentions. Just how responsive would inflation expectations be to such communications? General conclusions are unlikely, because the results will depend on the nature of communications, the nature of the accompanying actions, and the context in which they are received. ...

The outlook for inflation, then, is to an important extent contingent on policymakers' assessments of their ability to influence the evolution of inflation expectations. Such assessments will inevitably be inexact. Although there may be no precise historical analogs for communication and actions to reduce inflation expectations in circumstances like the present, my sense is that clear communications accompanied by consistent actions could bring about a relatively prompt and low-cost reduction in inflation.

But in any event, there is little disagreement about the central importance of inflation expectations for the conduct of monetary policy. Inflation expectations are an outcome of monetary policy, not an autonomous help or hindrance, and central banks are as responsible for the behavior of inflation expectations as they are for the behavior of inflation.