Matthew Billington
When Alan Greenspan led the US Federal Reserve—which he did for almost two decades—the market tried however it could to divine his thoughts about the direction of interest rates. Greenspan was often cryptic, which meant the media was left to cast about for clues as to his opinions—to the point of focusing on the size of the briefcase he carried to Federal Open Market Committee meetings.
But after Greenspan stepped down in 2006, the Fed’s approach changed. In an effort to better manage inflation expectations, the next chair, Ben Bernanke, brought more transparency to the Fed, and his successors largely followed suit.
Until now. Current chair Kevin Warsh has questioned this openness. Research by University of California at Berkeley’s Ulrike Malmendier and Chicago Booth’s Stefan Nagel suggests that Warsh may have a point.
Conventional wisdom holds that announced intentions to fight inflation can themselves help stabilize the economy, especially when those intentions include a clear inflation target. It’s believed that if households, companies, and financial markets trust that the Fed is committed to keeping inflation low and stable, their expectations remain anchored near that target, making actual inflation easier to contain. In that view, the Fed’s communications, including disclosure of its inflation target, interest-rate projections, meeting minutes, and press conferences, are not just explanations of policy but tools for shaping expectations and reinforcing its commitment.
Malmendier and Nagel surmised that such management of expectations might be ineffective and that what the Fed actually produces matters a lot more than what it says about its intentions. After all, past research (by Malmendier and Nagel, among others) suggests that people who lived through high-inflation periods such as the 1970s will remain wary that prices will surge, while people who lived through low-inflation times will be more at ease.
If so, inflation spikes, including the ones many economies experienced in the aftermath of the COVID-19 pandemic, are dangerous because they create inflation experiences that influence personal forecasts for decades. If consumers and businesses expect high inflation, it can make keeping inflation in check tougher for the Fed.
The researchers documented this by measuring inflation expectations over time and economic cycles using the University of Michigan Surveys of Consumers, which provides inflation expectations at a horizon of 5–10 years going back to the 1970s; the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters; and data from inflation-swap markets.
Experience as a guide
According to the researchers’ model, in which inflation experiences shape people’s beliefs, the Great Inflation of the 1970s led Americans to believe that inflation tends to persist. As memory of the 1970s faded and younger cohorts accumulated different inflation experiences, people came to view inflation as less persistent.
They find that people’s inflation expectations tend not to be significantly moved by what the Fed says it plans to do but are instead tied closely to the inflation history that the individuals have lived through. Rather than concern themselves with Fed forecasts, the researchers write, “individuals update their beliefs about future inflation based on inflation outcomes realized during their lifetimes.”
Anyone who believes in the power of inflation anchoring through central bank communication is confusing cause and correlation, according to the study. Present-day Americans’ apparent faith in the Fed’s ability to manage the economy didn’t come from the agency’s transparent communications but from the fact that many members of the public have experienced conditions of mostly low and stable inflation.
Inflation was subdued for several decades prior to the COVID pandemic. The post-COVID inflation spike was relatively short, so people who had grown accustomed to low inflation were able to largely ignore the shock and to expect a return to what they were used to. Still, it shook some of that earlier confidence, and it might have destroyed it altogether had it been more persistent, the researchers write.
Their study suggests that hope doesn’t triumph over experience when it comes to inflation expectations. Since the Fed can’t actually guide people’s decisions by committing to future policy choices, it can only maintain its credibility by producing results.
“In the experience-based learning model, central bank actions affect expectations through their influence on individuals’ realized inflation histories, rather than through communication about long-run policy targets,” Malmendier and Nagel write. “By the same logic, the future stability of inflation expectations depends critically on maintaining low and weakly persistent realized inflation.”
- Ulrike Malmendier and Stefan Nagel, “Seemingly Anchored Inflation Expectations,” Journal of Monetary Economics, forthcoming.
- ———, “Learning from Inflation Expectations,” Quarterly Journal of Economics, February 2016.
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