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The Fed's Inflation Jedi Mind Trick

Ramesh Ponnuru is a Bloomberg View columnist. He is a senior editor of National Review and the author of “The Party of Death: The Democrats, the Media, the Courts, and the Disregard for Human Life.”
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Inflation expectations have been falling for months, and that has some people worried. They say that the Federal Reserve should raise those expectations, which would bring real interest rates down and encourage people and businesses to spend money. I'm not going to pass judgment here on whether the worriers are right; I've already said my piece on why raising inflation rates isn't a sensible goal for the Fed.

Instead, I want to talk about a different question that a lot of discussions of monetary policy (including my own) usually skip over: How can the Fed guide expectations of inflation -- or of related variables, such as nominal spending -- when three-quarters of Americans don't know who Janet Yellen is? (She's the Fed chairman, but as Bloomberg View readers you're part of the informed quarter.) If the Fed concludes that the public's inflation expectations need to be raised, yet the public is mostly clueless about monetary policy, what can it do?

Part of the answer is that people make observations about the changing economic circumstances that they and those they know go through and form expectations based on that. My guess is that a lot of people didn't know that Paul Volcker was chairman of the Fed in the early 1980s, let alone what kind of open-market operations he was overseeing. Yet surveys still found that people's expectations of inflation dropped and stabilized during that period -- and these expectations were roughly borne out.

Surveys don't tell an important part of the story, though. The great Austrian economist Friedrich Hayek often stressed the point that the price system enables people to act on information they don't consciously possess. You don't need to know that demand for oil is surging elsewhere in the country, for example, to know that you should try to drive less: The price of gas communicates what you need to know.

Something similar happens when it comes to monetary conditions. You don't need to know anything about the Fed for its policies to be reflected in crucial prices -- and to thereby affect your behavior. Rising expectations of inflation, or nominal spending, should, all else equal, be reflected in rising interest rates. You might not personally be able to offer anything but a blank stare when asked how high you expect the inflation rate to be over the next five to 10 years. Yet you will still borrow and lend money at rates that assume an inflation forecast.

One of the most widely cited measures of expected inflation is the difference between the interest rates on Treasury bonds that are indexed for inflation and those that aren't. That difference can be read as a rough market forecast of future inflation -- one reached by traders who are highly informed and intensely interested in the correct answer.

What should we make of the fact that, by this measure, the market expects the inflation rate over the next five years to run well below the Fed's 2 percent-per-year target? Does it mean that the Fed can't shape inflation expectations after all, or at least can't do so now?

Quite a few commentators have argued that the central bank's ability to increase inflation is impaired in a depressed economy with very low interest rates. Another reading of the situation, though, is that the market is accurately reading the Fed's behavior to mean that it isn't serious about hitting its announced 2 percent target. The Fed's track record suggests that it's actually seeking to keep expectations between 1 percent and 2 percent per year, and hitting that target range quite well.

Whether or not the Fed's policies are the right ones, that is, they do seem to be effective -- even if Janet Yellen can travel incognito through most of the country.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Ramesh Ponnuru at

To contact the editor on this story:
Timothy Lavin at