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Economy in Brief

Are Inflation Expectations Moveable?
by Joseph G. Carson ([email protected])  September 4, 2018

Policymakers are increasingly relying on measures of inflation expectations in order to monitor potential changes in the inflation outlook. Yet, with general inflation steady and inflation expectations often no more than an extrapolation of past trends these measures do not offer the inflation vision that policymakers are seeking nor do they capture the price signals in the asset markets that were principally responsible for ending each of the past two economic cycles.

Moreover, there is some evidence that inflation expectations may be moveable in the sense that anchored inflation expectations in the real economy and the high probability that policymakers will continue to follow a predictable and relaxed monetary policy stance appears to have contributed to excessive optimism and heightened expectations of price appreciation in the asset markets. That should be a worrying development for policymakers as history has shown that large and persistent price movements in the real economy and the asset markets can and do have significant adverse macroeconomic consequences once they reverse.

Well-anchored inflation expectations have become an often-used phrase of policymakers as it is intended to send a signal that monetary policy is on the right track. Policymakers admit that inflations expectations are not easy to discern, nor do they know how they are formed. Nonetheless, policymakers use a combination of surveys and market-based measures to gain insight into the economy’s potential inflation dynamics. However, each measure of inflation expectations has its own shortcomings.

For example, one of more widely used measures of inflation expectations is the University of Michigan survey of consumer price expectations, Yet, research shows that future price expectations of consumers are heavily influenced by past experiences and therefore offer little insight into future trends. Surveys of professional forecasters inflation forecasts represent too small of a sample to be helpful and financial market based measures ---such as Treasury Inflation Protected Securities (TIPS)-- can be biased by liquidity issues.

Perhaps the biggest shortcoming in the measures of inflation expectations is that none of them include asset prices, such as equities and real estate. Yet, equity and house price trends offer a direct statement about investor and consumer expectations of the future, as well as present financial conditions. To be sure, equity prices reflect investor views of current and prospective earnings growth, the sustainability of the economic growth cycle as well as the level and potential change in interest rates. Moreover, new investment in housing reflects among other things affordability (which is directly linked to the level of interest rates) as well as people’s expectation of house price appreciation.

Policymakers might be perplexed and unsure how inflation expectations are formed in the real economy, but there should be no confusion about asset price expectations, especially in the context of the current policy framework. Today policymakers explicitly target general consumer inflation and are indifferent to asset inflation. In addition, the regular publication of policymaker’s economic forecasts and projections of official rates has helped increase transparency and the predictability of scale and the timing of future monetary policy actions. That has helped to reduce interest rate volatility and the level of long-term interest rates, fueling expectations of endless growth and future asset price gains.

As the monetary policy framework shifted in the late 1990s to an implicit inflation-targeting regime and then to officially targeting consumer inflation in 2012 there has been a noticeable and persistent shift in consumer and asset price patterns during economic growth cycles. Plainly, asset prices have consistently run faster than general consumer inflation and by an unprecedented wide margin.

None of this proves causation. But it is hard to arrive at the conclusion that the shift in the operating framework in monetary policy that directly targets general consumer inflation did not trigger a shift in expectations and risk-taking to areas of the economy and markets that are not targeted. The role of expectations in monetary policy deliberations must expand beyond inflation considerations since it quite obvious it can impact behavior and create price imbalances in other areas as well.

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