Jun 12, 2021
Hot U.S. Inflation Could Stir Once-Sleepy Household Expectations
(Bloomberg) -- U.S. inflation is back in the news after being dormant for years, potentially affecting how Americans think about price pressures after not thinking about them much at all.
The Federal Reserve says expectations that inflation will stay near its 2% target will help to ensure the current surge in consumer prices, which jumped 5% in May, will be temporary. Chair Jerome Powell can expect questions on this at his post-meeting press conference Wednesday.
To explore that assumption and find out more about how Americans form such views, we spoke to Yuriy Gorodnichenko of the University of California, Berkeley, and Michael Weber of the University of Chicago’s Booth School of Business.
They are among the leading economists digging into what a local shopkeeper or family next door understand about central banking. Among their findings is a divergence between expectations formed by investors versus normal households, a significant gap given the Fed relies heavily on signals extracted from financial markets on what inflation will be in five or 10 years’ time.
Those currently suggest inflation will stay in check, which is one reason the Fed expects to hold interest rates near zero at least through 2023. Data released Friday from the University of Michigan also showed consumers expect prices over the next five to 10 years to increase 2.8%, compared to 3% last month.
But if the views of households decouple from market and start to rise faster, the Fed’s policy setting could be too loose, forcing it to admit a policy mistake and tighten faster.
This interview has been edited for brevity and clarity.
Are people aware the Fed has shifted to a 2% average inflation target?
Yuriy: Immediately after the Fed made that announcement we ran an experiment jointly with the Cleveland Fed where we asked people how much they heard about this, and how much they understood it. In a nutshell, very few people heard about it and you had a small fraction of people who understood it. People are largely unaware of what the Fed’s doing.
Michael: In 2018, we asked 20,000 households in the U.S. what is the inflation rate the Fed is trying to achieve? More than 40% of households said 10% or higher.
Do households think about prices differently than investors?
Yuriy: The Fed traditionally focuses on the expectations of financial markets and professional forecasters, and occasionally they mention households and firms. Historically, in macroeconomics, people thought these agents had the same expectations. Our research suggests that is probably a stretch. Households and firms in countries like the U.S. with low and stable inflation have few incentives to pay a lot of attention to inflation.
Are market expectations different from households?
Michael: The type of inflation the Fed often tries to focus on is core inflation, not volatile price series like food and energy. Often times the price changes originating from these series tend to be temporary and don’t indicate persistent inflationary pressures. But based on our research those are the very type of price changes that households and firms tend to focus on a lot in their daily lives and how they form expectations on inflation.
You can see quite a wide gap between what the Fed thinks about inflation pressures, what markets expect, and what households and firms think will happen going forward.
What is this risk that current higher prices rebase expectations to a higher rate?
Yuriy: People do talk a lot about inflation today. And people may be scarred by inflation experienced in their lifetimes. For example, I lived with hyperinflation in Ukraine. You always have concerns about runaway inflation. In the Great Recession, there was a huge increase in oil prices and an increase in inflation expectations of households. There was a fear that we were debasing the dollar and we were going to create a lot of inflation. None of that happened. Oil prices collapsed and so did inflation expectations. In short, it is normal to have those fears. But I don’t think there is any scenario that is going to create sustained, chronically high inflation.
How do you explain central bank success in delivering low inflation if public expectations can be so different?
Michael: The Fed has done such a credible job over the past decades to keep inflation low and stable, that nobody cares about monetary policy. Households and firms display what we call rational inattention. In other words, households and firms choose to not know much about inflation because it is not a big issue. Nevertheless, household and firm expectations are more volatile. They have no idea what forward guidance is and what the inflation target is.
Explain why public inattention can hurt credibility
Yuriy: Imagine if you lived in Germany, or Argentina, or Ukraine, countries with histories of hyperinflation. In these places, people really understand the importance of having an independent central bank. If over time the central bank is very successful in keeping inflation low and stable, this belief may get eroded. The irony here is that if the Fed is very good, people will not think it is a very valuable institution and you can get all kinds of pressures to finance programs or print money. By being successful you can actually create pre-conditions for something bad.
What kind of communication works best?
Michael: We have tried to understand, using Finnish data, what a central bank should communicate. Is it instruments or targets? The way to think about instruments -- QE and large-scale asset-purchase programs -- central banks implement them and then households and firms have to understand what they mean for inflation and consumption. Look at that versus directly telling them similar to what Draghi did in 2012. (He said:) I am not going to tell you exactly what I am going to do, but trust me it will be enough. Some people call that constructively imprecise. In other words, just tell them we are going to keep our foot on the gas until we reach an unemployment rate of X percent. To the extent the central bank has a high degree of trust and credibility, that might be all it takes to achieve this target.
Are the Fed’s forecasts an effective tool?
Yuriy: We found that people pay attention to the current rate and maybe one year ahead, and everything after that is noise. The marginal value of giving them an extra year of data is not very high.
This goes back to what Michael was describing. What should we tell people? Should we tell them that the Fed funds rate is going to be such and such number?Or should we tell them, “Everything is going to be fine. Just trust us!” The research is telling us that just telling people everything is going to be OK, everyone will have jobs and we will have stable prices -- that should be enough.
If you go to the dentist’s office he isn’t going to tell you what kind of equipment he or she is going to be using, how the sealer is going to work. All you are told is, “It is going to be fine.” Keynes said he wants economic policy to be as boring as dentistry. Maybe we are at that stage.
How effective do you think Fed communication with households has been?
Michael: If you think about the traditional target of central bank communication -- financial markets and professional forecasters, and maybe a small subset of the media -- the Fed has done an incredible job in conveying their message. But when it comes to households and firms that is not really the case. I don’t know a single person who is not an economist who would go on the Fed’s website to gather information on inflation or the macroeconomy. Even if you forced them to read official information, there would be some discounting.
There is some research the Fed is engaged in to try and come up with more simplistic and entertaining ways of communicating with households. Think about the reggae songs of the Bank of Jamaica -- they were very entertaining, and they conveyed what price stability means. It is the emotional connection with reggae that conveys the message.
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