The underlying trend in inflation is driven by the laws of supply and demand, which are as applicable today as they ever were. Excess demand pushes inflation up; excess supply pushes inflation down. Central banks exploit this relationship, working to create excess demand or excess supply in the economy, to target the inflation rate.
A central role in this relationship between the economy and inflation is played by inflation expectations. The more anchored those expectations are, the more quickly the economy will find its way back to normal after an economic shock. This is known as the credibility dividend: a credible central bank will see inflation expectations well anchored at the target level and will have a relatively easy time restoring normality after a shock. What this means is that the underlying trend in inflation may become more stable as expectations become more anchored. In short, the more successful the inflation target is, the less obvious the relationship between economic shocks and inflation will become.
Currently, US expectations are very well-anchored:
The top chart shows the 5-year breakeven inflation rate while the bottom chart has the 10-year breakeven rate. Both are actually a bit lower now than at the beginning of the expansion.
As a result, we’ve seen very stable inflation:
The top chart shows the PCE implicit price deflator — the Fed’s preferred inflation gauge. The bottom chart shows the Dallas Fed’s trimmed mean PCE inflation gauge, which removes extreme movements from the index, reasoning that these are short-term deviations from a longer-term norm. Both measures have flummoxed the Fed as they have failed to hit their 2% target.
But the recent weakness in inflation expectations is probably contributing to this lower level of price pressure.
You can only have excess demand if consumers have enough wherewithal to purchase more stuff. That means being paid more in their role as workers. The Fed can remove limits on expansion, but that does not encourage them to increase wages and hire more workers. That requires believing demand (not just prices) is going to increase.
I kid you not. I came here thinking of writing about inflation expectations & wondered if anyone was still interested. I kid you not.
Oddly, I don’t agree with Stewart or Poloz.
It is true that expected inflation has been stable, but so has achieved core inflation. I think the relationship between the recent past (the last 6 months) and forecasts for the future (including 5 and 10 years out) has remained stable.
Most especially there is a name associated with credibility — Volcker. It is commonly claimed (citations needed) that he demonstrated that a commitment to price stability *could* be credible and that this credibility was useful. I don’t agree at all.
But mostly I disagree with Poloz. Poloz asserts (really assumes) that economies automatically return to “normal” and that devations from normal levels are due to unexpected monetary policy. This the monetarist or Scottish view (due originally to David Hume before Smith let alone Friedman). The argument in its defense is a “no true Scottsman” argument. The hypothesis was that fluctuations of output due to aggregate demand were short lived with mean zero, so long term averages were determined by the structural factors (that is the supply side). So deviations due to disinflation were expected to be short lived.
Now and for decades this has been a maintained assumption not a hypothesis. It is argued (with great confidence) that low output and high unemployment following disinflation must not be caused by low aggregate demand because no true demand driven fluctuations are long lasting. Output gaps are found to be stationary, because they are defined as stationary deviations from a non stationary process.
These claims which are tautological are also powerful and are used to dictate fiscal policy in Euro Bloc countries.
I think I will incorporate this comment in the post which I had considered writing (and now I guess I will).
Be sure and read this where I posted an equation about the role of inflation expectations on wage growth.
Interestingly, currently the actual y/y change in average hourly earnings and what this equation says it should be are identical and the fitted value is starting to rise significantly.
yry wage growth is misleading right now and distorted by the large drop in utilization in such a quick period. Inflation lags cycles and it not easily seen until the next recession is at your doorstep. YrY wages follow suit.
Arne, consumers are already purchasing enough “stuff”. They need not anymore. Anymore and you got a problem. Wages are already increased and the amount of workers haired is probably nearing its maximum capability until the cycle ends with only 3 million more hires in the next 3 years possible.
November inflation is gonna accelerate across the board. Oil rises due to increased liquidity and government hedonics no longer pushing down the cost of rent and medicine(which have created another illusion that crosses over onto wages). That is just a good example of sampling bias.
By this time next year, I suspect some of you will be head scratching on several fronts.
does the theory of inflation take into account the fact that half the population does not have enough money to demand any more than they already do. or that they do not have the leverage to demand higher wages.
or that ten percent of the population has so much more money than it needs… or even “wants”… that instead of buying more they “invest” in the stock market which absorbs their otherwise inflationary wage increases?