Sunday, April 18, 2021

Inflation expectations

This post follow's last week's post on inflation levels prompted by the big March increases in CPI and PPI, and the CEA tweetstorm response. (Also a longer post on the chance of inflation.)

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.


  1. They seem to want a quick burst of inflation (to 3%?) followed by a return to stable inflation anchored at 2%.

    Possible to accomplish?

    Why wouldn't people expect future bursts of inflation, throwing off the plan?

  2. /// 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 ///

    I will admit I was not alive in the 70s, but I feel like most recently the fed is usually accused of doing too much too early. They seem to raise interest rates before ever hitting the 2% target, and the market has huge reactions to even very modest/minor interest rate increases.

    If firms and businesses cut investment after a 0.25% interest rate, I can't imagine what the news cycle would be after just a 1 or 2% interest rate hike, but I feel it would be very significant.

  3. Well, maybe.

    On the other hand, highly credentialed macroeconomists have been predicting higher rates of inflation and interest rates for 40 years, including such luminaries as Martin Feldstein and Paul Volcker.

    The profession obviously did not expect the Federal Reserve to "keep a lid on inflation." But nothing happened anyway.

    The Reserve Bank of Australia has a 2% to 3% inflation band target, and Australia has been famously recession free until the pandemic. For a few seasons, here and there, in recent decades inflation in Australia reached up into 4% range. But then inflation retreated back into RBA's target range, although presently inflation is well below the RBA's target.

    But then, inflation is below central bank targets in China, Japan, and Europe.

    Well, maybe this is the year inflation "breaks out."

    Or maybe not.

    But just wait until next year!

  4. As we all know, there is no inflation.

    We had to buy a new car last week to replace my wife's 14 yro SUV which had started developing problems.

    A couple of things have happened in the automobile market.

    1. There is a tremendous shortage of computer chips for automobiles. Modern automobiles need 10 to 20 chips to work. Numerous manufacturers have been forced to curtail production.

    2. Some Americans have suffered a great deal from the pandemic. But for a lot of people the Pandemic lockdowns have fattened their bank accounts by limiting their ability to consume. Then Congress, in its wisdom (or lack thereof), decided to mail hundreds of millions of Americans checks for a couple of thousand dollars.

    With that much money burning holes in their pockets. lots of Americans went to shop for a new car.

    Low supply, high demand. I priced the model we wanted early in the pandemic. MSRP was $30,610. With customary discounts and our trade-in, I think I could have gotten it off the lot without financing for ~$20,000.

    Last week, the only vehicles available were the "premium" models (8way power leather seats) with lots of little extra goodies. Cargo liner; $270, Body Side Molding $210, Door Edge Guard $140, Mudguard, $110. Total MSRP $36,117. The check from us was $31,500.

    Inflation? Not officially. the same car last year probably had the same sticker. But, we would not have bought it. This year we had Hobson's choice.

    Anecdata? yes. But, it really does start to feel like like a 45 year old movie running again.

    1. "Inflation? Not officially. the same car last year probably had the same sticker."

      Surely inflation calculations must include actual transaction prices for new cars and not just MSRP.

  5. Previous poster clearly was taken advantage of at the dealership.

    it is true it's hard to find lower trims, but the prices have not changed for 14 years and the cars are infinitely better.

    1. Anonymous is invited to do better and show me the paperwork.

    2. I have family in the auto dealership industry and they tell profits are higher than they have ever been in the used market.

    3. "Auto Dealers’ Record Sales Take a Back Seat for Investors: Supply constraints lead to impressive profits today but raise real concerns about business for the rest of the year"

      By Jinjoo Lee | April 21, 2021 |

      A year ago, auto dealers saw their profits crumple as the pandemic hit both demand and supply: Consumers stopped buying as many cars as they hunkered down, while auto makers halted manufacturing. Today, they have hit a sweet spot. Consumers are eager to buy cars but manufacturing bottlenecks in things like semiconductors are limiting supply, lifting pricing for both new and used vehicles.

      Both AutoNation and Lithia Motors which sell new and used vehicles, blew past Wall Street expectations on their top and bottom lines. First-quarter sales jumped 27% and 55% for the two auto dealers, respectively, compared with a year earlier. The two also beat expectations on net income. The numbers represent significant bumps even compared with pre-pandemic 2019.

      Auto retailers have seen brisk business as they capitalize on tight supply for new cars. The average new-car price in March was 9.3% higher than a year ago, while used cars have gotten 14% more expensive, according to data from Edmunds. ...

  6. I will be genuinely curious if inflation breaks out, how the fiscal authorities would feel about the Fed ratcheting up the interest rates to 10 or 20 percent. Would they passively allow it?

  7. Your concerns suggest you've forgotten the obvious solution to an inflationary regime shift - vegetable gardens, per President Ford. Why are vegetable gardens so blantantly absent from economic theory?

    1. Bill, when energy sources dry up and prices spike in the winter, just put on a sweater like Jimmy Carter advised to conserve energy. Lol.

  8. Well, one view would be that the Fed is eager for more inflation, but confused about how to get there. What we're likely to see is Japanese syndrome. The Fed won't ever hike interest rates, and we'll continue to have inflation below 2% (at least beyond this fall).

  9. Inflation is easily managed in these circumstances. For example, the Job Gty/Green New Deal law should include AUTOMATIC across-the-board tax increases that kick in when certain monthly wage inflation target are hit-say for 6 months in a row. These can include:
    a) Income Taxes,
    b) Sales/VAT Taxes
    c) Asset Value (or Wealth) Taxes
    That'll cool things off pronto.

    In addition, Treasury/Fed can implement targeted measures depending on the source of the inflation, for example increasing downpayment and margin requirements on real estate security purchases.

    Easy Peasy!

    1. Are such taxes easy to implemented? How will it affect behavior? Are there no potentially severe distortion effects associated with such a policy? How likely are people to hold onto assets vs trigger sell offs in anticipation big higher taxes? How is wealth even being measured here?

    2. Or, heaven forbid, the law could include across the board spending cuts that kick in when an inflation target is hit. With the restriction that marginal tax rates cannot exceed 100%, DoDeals and company will sooner or later have to discover that one.

    3. A more serious follow up. Is it wise to tie fiscal policy to uncertain macro forces? Aren't we supposed to be doing fiscal policy in such a way as to make things as predictable as you can?

      Do we really want actors making decisions with even more uncertainty plopped on top? Or is it time to just throw everything into tax exempt fixed income assets?

    4. "Or, heaven forbid, the law could include across the board spending cuts that kick in when an inflation target is hit. With the restriction that marginal tax rates cannot exceed 100%, DoDeals and company will sooner or later have to discover that one."

      Maybe John Cochrane should address TIPs. Right now, the higher the inflation rate the higher the level of government spending on TIPs.

      Shouldn't this be the other way around - Treasury Deflation Protection securities (TDPs)?

      With higher inflation, the spending by government on it's securities should be negative (not positive).

  10. I was there in the 1980s when the interest on my operating loan hit 22.5%.

    I was here during the Obama era, and am still confused as to why we didn't have serious inflation.

    And I am here in 2021, watching housing, fuel, and lumber prices climbing - yet the the Biden administration and the Fed deny it.

    1. "How the Pandemic Made Lumber America's Hottest Commodity"

    2. I take everything that the Wall Street Journal puts out with a large grain of salt.

      Here are wholesale lumber and construction material inventories relative to sales:

      April 2020 - 1.77 : 1
      February 2021 - 1.47 : 1

      Notice that both of these values are SIGNIFICANTLY higher than what they were back in the 1990's.

      From 1993 to 2006, the average inventory to sales ratio for lumber and construction products was about 1.2 to 1.

      Post housing bubble crash, that value has risen and remained elevated.

      Also, as far a sawmill and lumber employment goes, that started cratering well before the pandemic set in:

      2000: 620 Thousand people employed in the production of wood products
      2006: 573 Thousand people employed in the production of wood products
      2010: 339 Thousand people employed in the production of wood products
      Jan 2020: 411 Thousand people employed in the production of wood products
      Apr 2020: 374 Thousand people employed in the production of wood products

  11. The US economy was quite different in the 1970s than today. We were a domestic economy with a positive balance of trade. American industry was largely unionized with built in wage increases. Even exempt employees expected Cost of Living adjustments annually plus merit increases. US firms did not learn to off-shore work until the 1980s.
    Today, there is still an abundance of global workers available at very low wages to take off the wage pressure. That is why inflation has been tame for the past 40 years.

    1. And yet lots of countries with big populations of low wage workers have experienced severe inflations

  12. Hi John:

    You don't even mention the biggest reason why the current government probably will not take the severe medicine of 1980. Back then, debt/GDP was 32%. Today, it's over 100%. Volcker's 20% interest rates (or anything even close to that) would bankrupt the country.


  13. MacBeth, Act 4 Scene 1

    THIRD APPARITION: "Be lion-mettled, proud, and take no care
    Who chafes, who frets, or where conspirers are.
    Macbeth shall never vanquished be until
    Great Birnam Wood to high Dunsinane Hill
    Shall come against him." [Descends]

    MACBETH: "That will never be.
    Who can impress the forest, bid the tree
    Unfix his earthbound root? Sweet bodements! Good!
    Rebellious dead, rise never till the wood
    Of Birnam rise, and our high-placed Macbeth
    Shall live the lease of nature, pay his breath
    To time and mortal custom. Yet my heart
    Throbs to know one thing. Tell me, if your art
    Can tell so much: shall Banquo’s issue ever
    Reign in this kingdom?"

    ... back to the future.

  14. It has taken me a while to appreciate the shallowness of the description by the CEA. It's unbelievable.

    Arithmetic at best, and a confusion of changes in relative prices with changes in the price level at worst: Inflation will be higher because it was low. Inflation will be higher because some stuff has disappeared. And inflation will be higher because some prices have risen.

    Why this moronicity? Because they think we're all stupid? Or because it sounds nice to some?

  15. I wonder what happens in a world where tax rates are tied to inflation like this? Any model results before we run this experiment in real time?

  16. "Lowness of interest is generally ascribed to plenty of money. But ... augmentation has no other effect than to heighten the price of labour and commodities ... In the progress towards these changes, the augmentation may have some influence, by exciting industry, but after the prices are settled ... it has no manner of influence.
    "[T]hough the high price of commodities be a necessary consequence of the increase of gold and silver, yet it follows not immediately upon that increase; but some time is required before the money circulates through the whole state ... In my opinion, it is only in this interval of intermediate situation, between the acquisition of money and rise of prices, that the increasing quantity of gold and silver is favourable to industry ... we may conclude that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in greater or lesser quantity. The good policy of the magistrate consists only in keeping it, if possible, still increasing... (David Hume, 1752) quoted in "Quantity Theory of Money", Milton Friedman. Money, The New Palgrave: A Dictionary of Economics, NY, 1987.

  17. It is easy to see MacBeth's fate occuring again. It is difficult to envision David Hume's optimal policy being achieved.

  18. Is inflation anticipated because of supply shocks related to the virus? Or using MV=PQ as a way to think about inflation; as productivity across the globe increases post pandemic, wouldn't prices remain relatively stable as price and quantity demanded are inversely proportional. Comments are welcome.

  19. for inflation to break out then you need what is called down under a wages break out. without that it just won't happen.
    Funny how both you and others whop insist inflation will break out simply ignore this.

    1. I wonder if we're not on the brink of such a "wages breakout"? Everywhere one sees "We're Hiring" signs, yet the daily paper is filled with employer complaints that they have no takers. At some point, some desperate employer is going to think to offer a little more. And as that practice catches on . . . here we go!

  20. Well, I say this every time but I will repeat it. You cannot have a discussion about inflation in America without noting the role of housing costs and property zoning.

  21. The CEA tweetstorm is a lot to take in and as a layman I'm confused by definition of inflation. Here is what I do know though:

    Unclogging supply chains is not a temporary action. Employers a pumping money at the problem because production is bottlenecked by a labor shortage exacerbated by the fact that the marginal benefit of working is very low relative to state+fed unemployment. To get people off the couch and to the plant floor we pay more.

    I guess I missed the part where humans are econs so wage rates arent going down - but employment may

    Price changes have passed through already- freight carriers are charging more and fewer companies offer guaranteed free next day. Consumers will adjust to getting less for more.

    These could be transitory changes - but what does CEA see as the unwind plan here? Supply chain is unclogged and businesses which found that they misread price elasticity over the past few years will suddenly charge less?

  22. You underestimate how stable the system under the current fiscal regime. The income tax system is graduated and capital gains and inventory profits are not indexed so that inflation increases real tax revenue. That is the source of fixed inflation expectations.

  23. Our Monetary Economics professor in the 1970's was Philip Cagan, who we called "P Dot," which is how he denominated the inflation variable. His famous result, looking at hyper-inflations, is that "the parameters of money demand functions estimated during hyperinflation generally satisfy the condition of dynamic stability that precludes the inflation from being self-generating, or displaying period-to-period oscillations." Stable monetary policy was assumed to lead to stable prices. Of course, the 70's were about oil and "supply shocks," but the real insight was the role of expectations (adaptive for Professor Cagan, which lead to the rational expectations insights according to Professor Muth's little model on commodities). I admit to not having much of a grasp of the New Monetary Theory, but the focus of the inflation years (1970-90) lead us expectations and actual fiscal and monetary policy. I find to convenient to go back to the origins and core ideas, and here the lesson was that expectations depend on information and using that information to make predictions of outcomes; and even if the information is the same among actors, the predictions are not. Muth might have better coined his article "Information and Expectations;" the term rational expectations is a little misleading.

    So, we are again at a point where the monetary and fiscal actions are troubling; and the question is when and how will that information be translated into most likely divergent expectations; and how will those expectation effect inflation.

    These are old memories; but it seems that someone - even professionals - under 40 to 50 will lack memories of the post Viet-Nam and post Great Society inflations experienced by the US Economy.

  24. I ask again on how the US will have a wages break out. It matters not if expectations are rising if agents have little power to lift wages

  25. Still No Inflation:

    "Procter & Gamble Will Raise Prices in September: Price increases on baby products, adult diapers and feminine-care brands come as the company reports slowing growth in latest quarter"

    By Sharon Terlap | April 20, 2021 |

    Procter & Gamble Co. this fall will start charging more for household staples from diapers to tampons, the latest and biggest consumer-products company to announce price increases.

    The maker of Gillette razors and Tide detergent cited rising costs for raw materials, such as resin and pulp, and higher expenses to transport goods.

    The announcement, which P&G said could be a precursor to broader increases, follows a similar move last month by rival Kimberly-Clark Corp.

    “This is one of the bigger increases in commodity costs that we’ve seen over the period of time that I’ve been involved with this, which is a fairly long period of time,” said P&G Operating Chief Jon Moeller, a 33-year company veteran.

    Mr. Moeller said P&G aims to improve and add features to products, as the company increases prices so that consumers feel they are getting more. The price increases, to take effect in September, will be on baby products, adult diapers and feminine-care brands and will be in the mid- to high-single-digit percentage points, the company said.

    The last time big consumer-products companies raised prices significantly because of materials costs was 2018, when surging pulp prices drove up the cost of diapers, toilet paper and other products.

    Global supply chains, already struggling due to the Covid-19 pandemic, have seen additional disruptions. The February freeze that triggered mass blackouts in Texas led to chemical-plant shutdowns and caused a shortage in raw materials that in turn sent prices for polyethylene, polypropylene and other chemical compounds to their highest levels in years.

    Kimberly-Clark, maker of Huggies diapers and Scott paper products, said its percentage increases would be in the mid- to high-single digits and take effect in late June. They will apply to the company’s baby- and child-care, adult-care and Scott bathroom tissue businesses.

    Several food makers have raised prices as well. Hormel Foods Corp. said in February that it raised prices on its turkey products, such as Jennie-O ground turkey, in response to higher grain costs. J.M. Smucker Co. said it recently raised prices for its Jif peanut butter and that it might do the same with pet snacks because of higher shipping costs and other inflationary pressure.

    The Labor Department said last week that its consumer-price index—which measures what consumers pay for everyday items, including groceries, clothing, recreational activities and vehicles—jumped 2.6% in the year ended March, the biggest 12-month increase since August 2018.
    * * *

  26. I can't say nothing about inflation. The only prediction I'm going to make is this: If we do start to get runaway inflation, no economic forecaster is going to predict it, but a year in all of them will say how obvious it was in retrospect. Book it.

  27. I had thought surveys on inflation rate changes were considered remarkably good compared to all other forecasting models (Ang et al. 2006). I have used this to believe in the efficient market hypothesis for the overall price level and the hope that it can be studied under rational expectations models. To me this is what the rational expectations revolution is all about, following by analog what Muth (1961) explained for the observations about surveys of prices in simple markets.

  28. This comment has been removed by the author.

  29. Okay, so where does the average guy hedge his retirement who is 5 years out? Or ten years out?


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.