Quick Note on the Fed and Inflation Expectations

Last Updated Apr 27, 2011 12:44 AM EDT

This is from my colleague, Fed Watcher Tim Duy, with a few additional comments of my own at the end:
Quick Note on Inflation Expectations, by Tim Duy: The FOMC will render judgment on the economy today, followed by the inaugural post-meeting press conference by Federal Reserve Chairman Ben Bernanke. Policy is expected to remain essentially unchanged, with the large-scale asset program continuing through June. The FOMC statement will likely be similar to the last, maybe upgrading the state of the labor market but acknowledging weak first quarter data. I am curious to what extent they have adjusted their full year GDP forecast. Any downward adjustment would be further reason to maintain the current path of policy, and it is difficult to see reason for any upward revision.

The statement will likely maintain language on commodity prices, inflation, and inflation expectations â€" commodity prices are likely to have only a transitory impact on core-inflation, while expectations remain stable or anchored. Rates will be kept low for "an extended period."

I am hopeful that the Chairman's press conference will be illuminating but ultimately something of a nonevent â€" that the general consensus on the direction of monetary policy is consistent with that of the gravitational center of the FOMC, and thus Bernanke's comments will be largely non-disruptive. Or at least it should be, as I anticipate we will learn that it was correct to heavily discount the more hawkish sounding regional bank presidents.

The Wall Street Journal focuses on the inflation expectations issue here and here. To be sure, I think the Fed is following this closely, but I think we should nuance the issue a little more carefully to account for a transmission mechanism from inflation expectations to actual inflation. I expect Bernanke would tie a discussion of inflation expectations to a discussion of labor costs. Vice Chair Janet Yellen did just that earlier this month:

In addition, the indirect effects of the commodity price surge could be amplified substantially if longer-run inflation expectations started drifting upward or if nominal wages began rising sharply as workers pressed employers to offset realized or prospective declines in their purchasing power--

--Consequently, longer-term inflation expectations became unmoored, and nominal wages and prices spiraled upward as workers sought compensation for past price increases and as firms responded to accelerating labor costs with further increases in prices--.

--That said, in light of the experience of the 1970s, it is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace. Such circumstances would clearly call for policy firming to ensure that longer-term inflation expectations remain firmly anchored.

For a more immediate example of what this would look like, turn to recent stories from China like this:
China's southern economic powerhouse Shenzhen said Thursday it would raise the minimum wage by 20 percent, following a similar move by Shanghai, as China continues to battle rising inflation and a labor shortage.
Sounds clearly like an economy in which inflation expectations have become unstable, to say the least. It is difficult to see a parallel to the current US situation â€" we don't have a labor shortage, without which there is minimal upward pressure on wages, rendering senseless fears a wage-price spiral is imminent. I suspect Bernanke would agree with a similar line of argument, and it will be interesting if he explicitly cites unit labor costs.

Finally, the series of questions I would like asked: "What specific outcomes or goals did you expect when you initiated QE2? Have you reached those goals? If you haven't reached those goals, are you preparing for QE3? Why or why not?"

I would also ask a question I first heard somewhere else today, "what is the normal, or natural rate of unemployment right now." This would help to determine the degree to which the Fed believes we are facing a cyclical as opposed to structural problem with employment. If the answer is that it's largely cyclical, then I would ask why the Fed isn't planning for QE3 as a means of addressing the problem. Is inflation the worry? If not, what is?