MNI:Fed Price Patience May Jolt Expectations Too Far- Ex-Staff

The Fed's downplaying of faster inflation may send price expectations lurching higher than policy makers want and force a messy rethink of their stance, ex-staffers and advisers told MNI.

"My chief concern is that the Fed will repeatedly state that its long-run target is 2% but that its actions will prove inconsistent with that rate, and then people's expectations will jump suddenly, leaving the Fed in the lurch," said Dean Cruoshore, a former long-time economist at the Philadelphia Fed. Inflation could quicken to as fast as 5% next year, he said.

While Fed officials welcome some higher expectations that would help meet their inflation goals, it's unclear how long the CPI can remain elevated before such increases are built into expectations.

"It can snowball," Tara Sinclair, a former visiting scholar at the St. Louis Fed, told MNI. "If inflation expectations move away, can the Fed do enough to bring them back in line? That is a genuine concern."

FED ADDING TO UNCERTAINTY

While inflation was expected to pick up from lows experienced in the depths of the pandemic last year, the recent spike, including annual rise of 4.2% in the CPI and a 3.6% jump in PCE inflation, has taken forecasters by surprise. Economists expect a bigger jump of 4.7% in CPI for the 12 months through May on Thursday according to the Bloomberg consensus, which would be the highest since 2008.

Stephen Cecchetti, former executive vice president and director of research at the New York Fed, also fears a possible upward spiral, though he is not yet seeing signs that recent price rises will persist.

The Fed's position of allowing the economy to overheat without pinning down the parameters "is just increasing uncertainty in a lot of different ways," he said in an interview. "Will rates rise suddenly? Will policy become more volatile?"

The Fed must communicate a plan as to how it will contain inflation and get ahead of any inflationary pressure, said Gregory Hess, a former visiting scholar at the Federal Reserve Banks of San Francisco, St. Louis, Cleveland and Kansas City. Policy maker comments so far saying the Fed has tools to bring inflation down in an overshoot aren't enough, he suggested.

"A majority of the recent spike in prices and measured inflation is transitory, as long as the Fed is willing to take action to take action so that it remains so," Hess said.

MEASUREMENT RISKS

Former staff economists say the Fed's new framework, which commits to waiting for full employment and a consistent return to its 2% inflation target before raising interest rates, increases the importance of inflation expectations as an early warning signal.

Yet the drivers of price expectations are less well understood and harder to measure, let alone control. Fed officials themselves sometimes disagree about whether to rely more on market-based measures or consumer surveys as a guidepost.

There are also doubts about what drives what -- inflation or expectations. Fed Chair Powell has argued inflation expectations are likely sticky and would not take off suddenly. Some current and former Fed economists fear otherwise.

"We've had these calendar effects of inflation picking up that have been intensified by the bottlenecks and I worry that it gets built into inflation expectations," said Vincent Reinhart, former director of the Fed Board's division of monetary affairs, in an interview. That could turn wage gains now being driven by problems matching workers and jobs into something more volatile, he said.

FED IS LOOKING PATIENT

"I don't think we measure inflation expectations very well and I'm not sure you should bank a policy on something you don't measure well," Reinhart said.

St. Louis Fed President James Bullard told MNI in an interview last month he's comfortable with a post-crisis increase that has taken five-year market-based expectations as high as 2.65%, the highest since 2006, but suggested any further substantial gains would warrant a re-examination.

"If longer-term inflation expectations rise more than 0.5 percentage points, they might feel the need to act," ex-Fed board economist Joseph Gagnon told MNI. "They are going to be very patient about actual inflation this year, believing it to be transitory."