​MNI: Fed's Mester Warns Against Complacency on Inflation

Supply shocks during the Covid-19 pandemic could raise inflation expectations in a way that would prompt a policy response from the Federal Reserve and other central banks, challenging conventional wisdom that supply shocks have little impact on longer-term inflation, Cleveland Fed President Loretta Mester said Wednesday.

U.S. inflation expectations at the five-to-10-year horizon are rising, and households' survey responses are becoming more dispersed, she said in remarks prepared for the ECB conference in Sintra. Persistently high gas and food prices also signal some risk that the longer-term inflation expectations of households and businesses will continue to rise. (See: MNI: Inflation Expectations Already Unmoored -Ex-Fed Officials)

Econometric models at the Fed suggest "the more costly error is assuming inflation expectations are anchored when they are not," which would lead to a looser setting of policy than warranted and a vicious cycle for inflation, she said.

"These simulation results, coupled with research suggesting that persistent elevated inflation poses an increasing risk that inflation expectations could become unanchored, strongly argue against policymakers being complacent about a rise in longer-term expectations."

SUPPLY SHOCKS

Top Fed officials have endorsed another 0.75-percentage-point rate increase next month after laying out a path to a restrictive monetary policy stance by next year. The fed funds rate is currently trading in a 1.5% to 1.75% range.

The low inflation readings in the pre-pandemic expansion led policymakers to err on the side of being too accommodative, but, "the current challenging situation in which a sequence of supply shocks have contributed to inflation being at a 40-year high belies that view," Mester said.

"It also calls into question the conventional view that monetary policy should always look through supply shocks. In some circumstances, such shocks could threaten the stability of inflation expectations and would require policy action."

Calling the current inflation situation a "very challenging one," Mester added: "Central banks will need to be resolute and intentional in taking actions to bring inflation down."