|WIN button from the Ford Administration|
Is inflation coming? The CEA goes on to
Over the longer-term, a key determinant of lasting price pressures is inflation expectations.
And takes comfort that survey expectations don't see a large increase in inflation. But when did survey expectations ever predict inflation? In fact most research on surveys, especially in finance, is used to claim people are dumb and terrible at predicting the stock market and other variables.
The CEA goes on to
An increase in inflation expectations from an abnormally low level is a welcome development. But inflation expectations must be carefully monitored to distinguish between the hotter but sustainable scenario versus true overheating.
But if after "carefully monitoring," when it becomes impossible to make excuses, it looks like inflation is breaking out, what do you do then?
This analysis seems common, the consensus verbal model in the beltway, and I don't pick on the CEA. They just expressed it will. The idea is basically ISLM, with expectations. Inflation equals expected inflation plus (coefficient) times output gap, Phillips curve style. But the expectations are an independent force.
Where do these "expectations" come from? If they do get "unanchored" how do you put them back in the bottle? Better speeches? More tweets? WIN buttons? The Fed and observers repeats it has "the tools" to reanchor expectations. But what are those tools exactly?
Here is what we learned in the 1970s, which seems now forgotten as economic history: Expectations are formed by actions, by clear unambiguous commitments, by a policy regime. They are not formed by speeches and cute buttons. And we don't even have the speeches -- just what does the Fed even promise to do if inflation breaks out?
The only possible story I can think of is that inflation expectations are "anchored" because people expect that in the event inflation really breaks out, our government will swiftly take action -- there will be strong monetary and fiscal response. We will replay the early 1980s even if it does cost 1980s style recessions This time the response will likely be need to be heavily fiscal as well as monetary.
The government has that tool. But do people believe that it will use it? Will this government and Federal Reserve, if faced with 1970s style inflation, really raise interest rates to, say, 20%, and really undergo the kind of sweeping tax and spending reform needed to stabilize such an inflation? That will mean a recession with the opposite of bailout, money printing and stimulus that we did the last two times. Or will we see excuse after excuse, temporary factors, justified fear that recessions will hurt the disadvantaged more than others, and just have more speeches or WIN buttons about how expectations should go down. Or, simply say, as so many on the left advocated in the 1980s, that living with inflation is a better option?
So when do expectations become unanchored? Simple: When people decide that our government will not take the swift and painful fiscal and monetary actions needed to control inflation, if inflation should break out.