High US inflation could revive the expectations of once-asleep households



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(Bloomberg) – U.S. inflation is back in the news after being dormant for years, potentially affecting the way Americans think about price pressures after not giving it much thought.

The Federal Reserve said expectations that inflation would stay close to its 2% target would help ensure that the current surge in consumer prices, which jumped 5% in May, will be temporary. President Jerome Powell can expect questions on the matter at his post-meeting press conference on Wednesday.

To explore this hypothesis and learn more about how Americans form such opinions, we spoke to Yuriy Gorodnichenko from the University of California at Berkeley and Michael Weber from the Booth School of Business at the University of Chicago.

They are among the leading economists who dig into what a local trader or a neighboring family understands about the central bank. Among their conclusions is a divergence between the expectations formed by investors and those of normal households, a significant gap given that the Fed relies heavily on signals from financial markets on what inflation will be in five or ten years. .

These currently suggest that inflation will stay under control, which is one reason the Fed expects to keep interest rates close to zero until at least 2023. Data released on Friday by the University of Michigan also showed that consumers expect prices to increase by 2.8 over the next five to ten years. %, compared to 3% last month.


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But if household opinions decoupling from the market and start rising faster, the Fed’s policy could be too loose, forcing it to admit a policy error and tighten faster.

This interview has been edited for brevity and clarity.

Do people know that the Fed has moved to an average inflation target of 2%?

Yuriy: Immediately after the Fed made this announcement, we ran an experiment jointly with the Cleveland Fed where we asked people what they had heard about it and what they understood. In a nutshell, very few people heard of it and you had a small fraction of people who understood it. People are largely unaware of what the Fed is doing.

Michael: In 2018, we asked 20,000 households in the United States what the rate of inflation the Fed is trying to achieve? Over 40% of households said 10% or more.

Do households think of prices differently from investors?

Yuriy: The Fed has traditionally focused on the expectations of financial markets and professional forecasters, and sometimes mentions households and businesses. Historically, in macroeconomics, people believed that these agents had the same expectations. Our research suggests it’s probably a stretch. Households and businesses in countries like the United States where inflation is low and stable have little incentive to pay close attention to inflation.

Are market expectations different from those of households?

Michael: The kind of inflation the Fed often tries to focus on is core inflation, not volatile price series like food and energy. Often the price changes from these series tend to be temporary and do not indicate persistent inflationary pressures. But based on our research, these are the very type of price changes that households and businesses tend to focus a lot on in their day-to-day lives and the way they shape inflation expectations.


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You can see a pretty big gap between what the Fed thinks about inflationary pressures, what the markets expect, and what households and businesses think will happen in the future.

What is the risk that today’s higher prices will rebase expectations for a higher rate?

Yuriy: People talk a lot about inflation today. And people can be affected by the inflation they experience during their lifetime. For example, I have lived with hyperinflation in Ukraine. You still have concerns about soaring inflation. In the Great Recession, there was a huge increase in oil prices and an increase in household inflation expectations. There was concern that we would depreciate the dollar and that we would create a lot of inflation. None of this happened. Oil prices have collapsed, as have inflation expectations. In short, it is normal to have these fears. But I don’t think there is a scenario that will create sustained and chronically high inflation.

How do you explain the central bank’s success in generating low inflation if public expectations can be so different?

Michael: The Fed has done such a credible job over the past few decades to keep inflation low and stable that no one cares about monetary policy. Households and businesses display what we call rational inattention. In other words, households and businesses choose not to know much about inflation because it’s not a big deal. Nevertheless, the expectations of households and businesses are more volatile. They have no idea what forward guidance is and what the inflation target is.


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Explain why public inattention can damage credibility

Yuriy: Imagine if you lived in Germany, Argentina, or Ukraine, countries with a history of hyperinflation. In these places, people really understand the importance of having an independent central bank. If, over time, the central bank is very successful in keeping inflation low and stable, this belief may erode. The irony here is that if the Fed is very good people won’t think it is a very valuable institution and you can be under all kinds of pressure to fund programs or print money. By being successful, you can actually create the preconditions for something bad.

What type of communication works best?

Michael: We have tried to understand, from Finnish data, what a central bank has to communicate. Are these instruments or targets? The way to think about the instruments – QE and large-scale asset purchase programs – central banks implement them, then households and businesses need to understand what they mean for inflation and consumption. Look at this rather than telling them directly what Draghi did in 2012. (He said 🙂 I’m not going to tell you exactly what I’m going to do, but trust me, that will be enough. Some people call it constructively imprecise. In other words, just tell them we’re going to keep our foot on the gas until we hit X percent unemployment. To the extent that the central bank enjoys a high degree of confidence and credibility, this could be sufficient to achieve this goal.


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Are the Fed’s forecasts an effective tool?

Yuriy: We’ve found that people are paying attention to the current rate and maybe a year in advance, and all of that is noise. The marginal value of giving them an extra year of data is not very high.

It goes back to what Michael was describing. What should we tell people? Should we tell them that the Fed funds rate is going to be such and such a number? Or should we tell them, “Everything is going to be fine. Trust us ! Research tells us that just telling people that everything will be fine, that everyone will have a job, and that we will have stable prices – that should be enough.

If you go to the dentist, he won’t tell you what kind of equipment he’s going to use, how the sealant is going to work. All you are told is, “It’s going to be fine.” Keynes said he wanted economic policy to be as boring as dentistry. Maybe we are at this stage.

How effective do you think the Fed’s communication with households was?

Michael: If you think about the traditional target of central bank communication – the financial markets and professional forecasters, and perhaps a small subset of the media – the Fed has done an incredible job in getting its message out. But when it comes to households and businesses, that’s not really the case. I don’t know a single person who isn’t an economist who would go to the Fed’s site to gather information on inflation or macroeconomics. Even if you forced them to read the official news, there would be discounts.

There is research the Fed is engaged in trying to find more simplistic and entertaining ways to communicate with households. Think of the reggae songs from the Bank of Jamaica – they were very entertaining, and they conveyed what price stability means. It is the emotional connection with reggae that conveys the message.

© 2021 Bloomberg LP



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