“The Federal Reserve has come to view inflation expectations as playing an important role in what happens to prices.”, Justin Lahart, “The Age-Old Inflation Issue”, The Wall Street Journal
“After the 2008 financial crisis the media and even some economists wondered aloud, “How could Americans rationally think home prices would always continue to rise?” The answer is simple. The Federal Reserve’s long-standing policy is not stable prices (one of their two mandates under the law), but modest inflation in prices. I don’t think many Americans understand that the Fed, for decades, has deliberately and unilaterally re-interpreted their Congressional “stable prices mandate” to mean that they should foster monetary inflation of around 2% a year. Why modest monetary inflation and not modest monetary deflation, or neither? Because monetary inflation encourages consumers and business to spend (and borrow) today, rather than wait, because prices will be higher in the future as a result of Fed-created monetary inflation. This also encourages our federal, state, and local governments to do the same; spend and borrow. Why does the Fed believe this is good? Because it stimulates economic activity in the short-run (I am not an economist, so not so sure about the long-run effect.). However, the Fed’s distortive monetary policy (always inflation) can and does distort economic activity. It encourages more spending, borrowing, and speculation than would otherwise be the case. It creates a rational expectation that prices for goods and services will rise about 22% every 10 years (the compounding of 2% annual monetary inflation) and that the nominal price of homes will rise 82% over the life of a 30-year mortgage. The Fed’s monetary inflation policy combined with other government housing and mortgage policies and normal economic issues (like restricted supply due to land or zoning constraints, vibrant regional economies, etc.) to create the rational expectation in individual Americans, Realtors, home builders, their lenders, their insurers, the bond rating agencies, mortgage investors, economists, (Fannie, Freddie, HUD, FHA, and VA), banking regulators and governments at all levels in the United States, that nationally, nominal home prices would always rise. In fact, in the mid-2000’s, then Chairman of the Federal Reserve Alan Greenspan told Americans that nationally, nominal home prices had never fallen (even one year) since The Great Depression and he made clear that the Fed and other renowned economists (including Nobel Laureate and monetary expert Milton Friedman and future Fed Chairman Ben Bernanke) had extensively studied this historic event and as a result, the Fed believed it could prevent another Great Depression from occurring. That’s why pre-crisis nearly everyone developed the rational expectation that nationally, nominal home prices (which reflect the economy generally) would not decline and acted accordingly, in their economic activities. (By way of example, the government’s FHA assumed nominal home price appreciation of 4% a year in perpetuity in it reverse mortgage product.) Now that we have endured the 2008 financial crisis, we know the Fed was wrong (about national, nominal home prices) and we now understand the distortive effect of the Fed’s monetary inflation policy and wise investors will act accordingly and cast a very skeptical eye towards the Fed, and its policies and pronouncements”, Mike Perry, former Chairman and CEO, IndyMac Bank
The Age-Old Inflation Issue
By Justin Lahart
The Federal Reserve has come to view inflation expectations as playing an important role in what happens to prices. Maybe who is doing the expecting matters as well.
One reason the Fed hasn’t seemed particularly alarmed by the cooling in inflation that lower gasoline prices and the higher dollar have brought on is that inflation expectations haven’t moved. Indeed, the Federal Reserve Bank of New York on Monday said its January survey of consumers showed people expect inflation of about 3% over the next three years. That is just a fraction less than the 3.05% they expected a year ago. (People consistently guess high on where inflation is heading.)
The Fed survey also shows how much age matters for inflation expectations. People over 60 expect inflation to come in at 3.4%, while people under 40 expect it to be 2.8%. This represents a shift from the 1970s and 1980s when University of Michigan data show it was the older cohort who expected less inflation.
Expectations are supposed to work their way into actual inflation in part because they affect the prices people are willing to pay. But the differing age-based expectations show why that might not always be so. Older Americans’ view tends to be colored by living through inflationary times. And, because they often live on fixed incomes, such people are sensitive to the prospect of inflation eroding their purchasing power. But the result is that older Americans who expect higher inflation may be inclined to purchase less. That would be because they feel the need to conserve capital.
Since this would have a deflationary effect, the Fed might want to pay more attention to what is, or isn’t, worrying the younger set.