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The Fed's Inflation Fail

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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Most central bankers would agree that their primary goal is to give people and companies confidence that inflation will remain stable over the long term. Unfortunately, the U.S. Federal Reserve may be failing at that task.

The Fed began pulling back on its efforts to stimulate growth back in May 2013, when then-Chairman Ben Bernanke said that the central bank would likely begin to reduce the bond-buying known as quantitative easing. The move indicated that Fed officials thought the inflation rate would gradually return to 2 percent over the next several years, a development that should maintain people's inflation expectations at a similar level.

So what has actually happened to inflation expectations over that period? To get a sense, we can examine a few clues: how employers set wages, what people say in surveys, and what investors will pay for protection from inflation.

Let's start with wages. Many economists have expressed surprise that very low unemployment hasn't translated into greater wage growth. One good explanation is that the unemployment rate isn’t capturing all the available labor supply, such as people who want jobs but aren't actively looking for work (and hence aren’t counted as unemployed). But I doubt that’s the full story.

Expectations matter, too. When, for example, inflation accelerated in the 1970s despite high unemployment, part of the problem was that people and companies had come to expect wages and prices to rise, and thus set their own wage demands and pricing policies accordingly. Now that inflation remains low despite low unemployment, this should be seen as a sign of the opposite problem: Expectations have declined. The explanation makes even more sense if you believe, as many do, that demand for labor is already bumping up against the limits of supply.

Household surveys support the idea that inflation expectations have declined. The University of Michigan consumer survey, for example, shows that expectations for inflation over the next five years have fallen to near record lows (though these measures admittedly stay within a relatively narrow range). The newer Survey of Consumer Expectations, from the Federal Reserve Bank of New York, finds that the median household's expectation for inflation over the next three years has decreased by nearly a full percentage point since June 2013.

Financial markets, too, appear to have lost faith that inflation will stay near 2 percent. Consider what the difference in prices on regular and inflation-protected Treasury bonds implies the average inflation rate will be over the five-year period starting five years from now:

By this measure, long-term inflation expectations have trended downward since the third quarter of 2014. To be sure, such financial market measures tend to be volatile. That said, the signal seems clear: Investors are less confident that the Fed is willing and able to keep inflation close to the 2 percent target in the future. (The above measure pertains to inflation as tracked by the Consumer Price Index, which runs about 0.3 percentage point above the Fed’s preferred measure.)

The Fed has delicately noted this signal from financial markets. In October 2014, the policy-making Federal Open Market Committee dropped from its regular post-meeting statements the explicit assurance that longer-term inflation expectations remained stable -- an assurance that had been in every statement over the previous five years. I don’t expect this phrase to return after the committee concludes its meeting on Wednesday.

Thus, we see widespread signs of a decline in long-term inflation expectations. We know the potential consequences from the experience of Japan, which has suffered more than one "lost decade" of extremely low inflation and disappointing growth. If it’s not remedied, interest rates and inflation will remain low, and the Fed’s ability to buffer the economy against adverse shocks to prices and employment will remain greatly restricted. 

What to do? President Jeffrey Lacker of the Federal Reserve Bank of Richmond put it well when he said in 2006 that the central bank must respond "vigorously" to any erosion in inflation expectations. He was talking about upward movements in expectations, but I would hope that the Fed would also heed his wise words in confronting the current downward slide, and use all the tools in its arsenal -- including, for example, talk of negative rates -- to convince people that it can and will do its job.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net