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Should the Fed Worry More About Inflation Expectations?

inflation-compensationExpected inflation has fallen sharply since last summer, and the European Central Bank and the Fed have responded in very different ways.  The European Central Bank launched quantitative easing, while the Fed has been biding its time.  If businesses, consumers, and investors expect inflation to fall, they will begin to act in a way that will make that happen.  Market based measures of inflation, such the difference in yields between regular and inflation-indexed bonds, began to fall last summer with the fall in oil prices.  The fed has acknowledged the drop, but instead has placed its trust in the stability of survey-based measures.  The Fed also indicated earlier this week that they may raise interest rates sometime in the near future.  With conservative language, Yellen noted that the FOMC would take interest rates on a meeting by meeting basis and has relaxed her emphasis on longer term patience.  Some analysts predict an interest rate raise by June.  Low inflation might undermine the hopes to raise interest rates, as the Fisher effect notes the importance of inflation in determining nominal interest rates.



  1. HeeJu HeeJu

    I am curious about what caused the ECB to react so readily to the drop in expected inflation yet the FED to overlook its significance. As the article presents, the FED has once neglected to notice the flattening yield curve in 2005 and 2006 as the precursor to recent global recession. Could the FED be committing the same mistake again, this time arguing that the drop in expectations is mostly technical?

  2. The yield curve as of yesterday’s rates implies 5-year forward yields on 1-year bonds of 2.66% which suggests a combination of low growth and low inflation. Now what can the Fed do about this? As far as I can tell QE in the US did little (but cost nothing). With 10 year bonds yielding 2.03%, long rates haven’t risen since QE ended. One reason is perhaps the European QE plus the Japanese QE that has portfolio managers buying more US$ assets [hence a stronger US$ relative to the € and ¥). If we renew QE, maybe it will push down the exchange rate a bit, but with mortgage rates already low, and fears of unsupportable prices in the stock market, there’s still not much benefit to be seen, and a perception of risks from mispriced assets. Maybe — lots of analysts have spilled words on this topic.

    As to deflation expectations generating deflation, that’s true with rational expectations. In the real world we don’t see much interaction of expectations with consumer behavior, nor do we find survey measures of inflation expectations shifting much. RE is a construct to explain dynamics under high inflation — the Milton Friedman article we read — and is a neat technique for solving models because it keeps them nicely convergent around long-run Solow growth. Is there empirical evidence that such models track the real world, e.g., provide a good prediction of the impact of austerity? My sense is, “NO”.

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