LAST week Janet Yellen addressed the Economic Club of New York about monetary policy, speaking with a sense of solemn tradition. The most thought-provoking part of the speech was when the Fed chair admitted to being ‘baffled’ by current inflation expectations.
But the decline is odd given that the economy has been expanding and that core consumer price inflation has risen slightly. This week the US Department of Commerce said domestic inflation - measured by the core rate on personal consumption expenditures, the Fed’s preferred inflation gauge - grew 1.7pc in February on a year-on-year basis, its highest level for three years. And Fed officials such as Ms Yellen keep telling the public that core inflation will rise in future to stable levels.
So what explains falling inflation expectations? One answer might be that investors and citizens are indeed more pessimistic about the economic outlook than the Fed, and have lost faith in the central bank’s ability to push prices higher using extraordinary monetary policy tools.
A second possibility is that the data on inflation expectations are distorted. Ms Yellen, for example, suggests that ‘market-based measures of inflation expectations’, such as Tips prices, are ‘driven by illiquidity concerns’. In plain English, she means that trading in the bond markets is so log-jammed that they are emitting false signals.
Another widespread theory is that the recent collapse in oil prices has affected the Tips market and the Michigan survey in peculiar ways. As Rick Rieder of BlackRock observes, falling energy costs have a disproportionately big impact for low-income households, and this might be skewing surveys about the path of inflation.
Both of these explanations probably contain some truth: consumers are more fearful about the economy than the Fed and are influenced by energy prices.
Technological shifts may also be changing the way in which consumers imagine prices. In the mid-20th century, western countries presumed consumer goods prices would rise over time and that wages, too, would increase throughout people’s lifetimes. These assumptions no longer hold true.
The cost of products with high cultural value and status, such as iPhones, tends to fall, not rise. And, as traditional employment structures unravel, consumers are learning that wages can also fall with age. Consumers do not see prices in a straight line of ‘inflation’ and ‘deflation’, as economists are apt to do, but rather as something fluid and volatile.
Perhaps this is the crucial point: what we need is not just economic analysis of price trends but on-the-ground ethnographic analysis of how consumer perceptions of prices operate. Scandinavian central bankers have looked at the social context of price trends, while last year the Fed published an intriguing paper on ‘Consumers’ Attitudes and Their Inflation Expectations’.
This suggested, consumers predict higher inflation when their household finances are under pressure.
If the Fed, or any central bank, wants an illustration of why ethnographic research matters, they need only look at the last credit bubble, when most economists missed the subprime mortgage boom because they shunned on-the-ground research.
Published in Dawn, Business & Finance weekly, April 4th, 2016
