Of all the days to pick for chatting up optimism on inflation’s outlook, this past Friday wasn’t ideal. Nonetheless, two voices from the Fed were on the rubber chicken circuit on March 23, expounding on the benefits that flow from enlightened monetary policy.
Philadelphia Fed President Charles Plosser told a bankers conference that “I anticipate that the yield curve is likely to be flatter, on average, than at comparable points in past business cycles. This is not to say that the yield curve is going to be inverted all the time, but, on average, I believe the curve will be flatter.”
The reason, he opined, was because inflation expectations had become less volatile. “My case for a flatter yield curve is based on two premises: first, inflation and inflation expectations are likely to be lower and more stable, and hence, the inflation premium will be smaller than in the past; and second, inflation and the real economy are likely to be less volatile, so the risk premium will be smaller.”
Although Plosser didn’t think an inverted yield curve would be a permanent fixture, he said he had “confidence in the fact that inflation in the United States is going to stay low and more stable [and that] means there is less reason for long-term rates to be above short-term rates.”
On the same day, Frederic Mishkin, a Fed governor, advised in a speech, “the data suggest to me that long-run inflation expectations are currently around 2%.” He went on to predict that core PCE “will gradually drift down from its latest twelve-month reading of 2.25%.”
To be fair, both men tempered their commentary with the usual caveats. Mishkin, for instance, spoke of the risks of trying to put a precise number on inflation expectations, which is by nature a warm and fuzzy concept. “We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate,” he said.
As it happened, the market’s view of inflation expectations ticked up on Friday to its highest since January. Based on the spread between the nominal 10-year Treasury and its inflation-indexed counterpart, the crowd prices future inflation at 2.43%. As recently as January 4, this measure of inflation expectations was as low as 2.26%. And if you go back to 2003, inflation expectations were under 2%. As a result, one could argue that expectations are going in the wrong direction lately.
It’s true, of course, that market-based predictions of inflation are in constant flux. And since the TIPS market has only a decade of history, it’s not yet clear that inflation expectations pulled from this corner are any better (or worse) than those dispensed by other formulas.
Still, various Fed heads have made it known that the central bank considers inflation expectations to be a critical driver of price trends over time. Mishkin on Friday offered the latest testimony to such thinking. “When we think about what drives trend inflation,” he said, “inflation expectations–particularly long-run expectations–come to mind.”
Mishkin also commented, “If inflation has indeed become less persistent because better monetary policy has anchored inflation expectations more solidly, the monetary authorities may find that they have less need to induce large swings in economic activity to control inflation.”
But if inflation expectations are second to none for monetary policy, does the rise of the nominal-TIPS spread bode ill? Not necessarily, Plosser suggested. Indeed, there’s a variety of methods for plotting inflation expectations, and the one cited by Plosser on Friday shows that “long-term inflationary expectations have come down and have become more stable.”
Meanwhile, a recent paper that’s caught the attention of central bankers the world over reminds once again that inflation is ultimately a monetary phenomenon, as Milton Friedman advised. But, the paper warns against relying on inflation expectations. That was fine when inflation was higher in decades past. But now that inflation has fallen to generational lows, such metrics are no longer as valuable for monetary policy.
The bottom line: central banks are running the show. The inflation buck stops at the Fed, and its counterparts around the world. By that standard, central bankers deserve praise for the decline and fall of inflation over the years. But the future looms, and on that front there’s always reason to worry, particularly now that central bankers seem to be patting themselves on the back about the past. As The Economist recently observed,
…today’s central bankers have little room for complacency. Inflation remains low and stable because policymakers are vigilant, not because any deep, structural changes insulate the modern economy from price pressure. If central bankers relax, higher, more volatile inflation could easily return.