MNI: Fed's Inflation Credibility Weakening--Weinberg

The Federal Reserve is in danger of allowing a dangerous unanchoring of price expectations, economists connected with the Fed system told MNI, with ex-Richmond Fed Research Director John Weinberg calling for officials to proclaim more decisively that they will not tolerate persistently high inflation.

"Rather than saying we have the tools to deal with it if it proves to be persistent, I would have hoped they would have said we have the tools to ensure it's not persistent," Weinberg said in an interview. "The whole point of central bank messaging is to affect expectations or reassure expectations."

Inflation has sharply outpaced Fed and market expectations, straining the argument that pressures will be fleeting. Consumer prices gained over 5% on an annual basis for three months running, while the Fed's preferred PCE measure doubles the 2% target.

Cost pressures may push headline and core inflation higher for months further, said Weinberg, adding that central bankers' mantra that they have tools to deal with persistent inflation if it materializes could itself feed higher inflation expectations.

"The only tool I know is a tightening that weakens economic activity, a greater-than-expected tightening, raising rates in a way that will disrupt economic activity and you don't want to end up there," he said.

Weinberg's concern is bolstered by research from Ricardo Reis, a consultant with the Richmond Fed and the Bank of England. The Fed's anchor of inflation expectations "drifted in 2021, but it is still early enough that good policy or good luck in the near future can keep it in place," Reis argued in a presentation at a recent Brookings Papers on Economic Activity conference.

MISSING CUES

The Fed appears to be behind the curve already because its gauges of inflation expectations are too multi-faceted and often conflicting, said Reis, who constructed his own measure of price expectations, testing it across countries and time periods.

"Expectations play a very important role and yet there's very little measurement of them directly playing a role in the discussions, which is a little paradoxical given how much progress the economic literature has made on the measurement of these things," he said in an interview.

One key lesson for Reis, who has also consulted at the New York and Minneapolis Feds, is not to seek false comfort from low bond yields and still fairly subdued market expectations, particularly as consumer expectations ratchet higher.

"Market expectations started really low, they increased quite considerably but then again they're not super high now -- so that tells you to take some pause, worry just a little bit. But then you look at the cross-section distribution. And then you see the last results of the Michigan survey, and you get very worried. The last round of the New York Fed survey shows the exact same thing."

The movements recall the late 1960s, when the Fed failed to stop the Great Inflation from taking hold, Reis said. (See: MNI INTERVIEW: Plosser Says Fed Policy Echoes 60s and 70s)

"Households did a big jump up on average in what they expect, and especially if you look at the distribution, it looks at lot like the 67-69 movement, where some people are panicking, they're thinking inflation is going to be 7% or 8% as well as this much slower shift around the mean. That combined with the markets gets you quite worried," said Reis.

Attempts to point to low 10-year bond yields as indicating contained inflation expectations echo similar arguments in the late 60s by then Fed Chairman William McChesney Martin.

"Then three years later, oops," said Reis. "This index that the Fed has been producing I think is actually biased towards finding very little and super driven by the survey of professional forecasters."

FRAMEWORK GROWING PAINS

The Fed's attempts to guide expectations are further complicated by its new long-run goals, which aim for a temporary yet undefined overshoot of the 2% inflation target, Weinberg says.

"When the committee released its revised statement of long-run goals, it could be read as the committee expressing that it wanted trend inflation to be higher than it had been for the previous 20 years. So that's saying you want a persistent increase in inflation -- but only a small one," he said, noting that this might prove as difficult as achieving the soft landing on inflation that the Fed has arguably never managed.

"There's a little bit of a space between saying yes we want a persistent increase in inflation, but we're confident that the increase we're seeing, which if it were persistent would be more than we want, is not persistent."