Anchors Aweigh!

By: Michael Ashton | Mon, Oct 19, 2015
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I think it is time to talk a little bit about "anchored inflation expectations."

Key to a lot of the inflation modeling at the Fed, and in some sterile economics classrooms around the country, is the notion that inflation is partially shaped by the expectations of inflation. Therefore, when people expect inflation to remain down, it tends to remain down. Thus, you often hear Fed officials talk about the importance of inflation expectations being anchored, and that phrase appears often in Federal Reserve statements and minutes.

I have long found it interesting that with as much as the Fed relies on the notion that inflation expectations are anchored, they have no way to accurately measure inflation expectations. Former Fed Chairman Bernanke said in a speech in 2007 that three important questions remain to be addressed about inflation expectations:

  1. How should the central bank best monitor the public's inflation expectations?
  2. How do changes in various measures of inflation expectations feed through to actual pricing behavior?
  3. What factors affect the level of inflation expectations and the degree to which they are anchored?

According to Bernanke, the staff at the Federal Reserve struggle with even the first of these questions ("while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks"), although this has not deterred them from tackling the second and third questions. Economists use the Hoey survey, the Survey of Professional Forecasters, the Livingston survey, the Michigan survey, and inflation breakevens derived from the TIPS or inflation swaps markets. But all of these suffer from the fundamental problem that what constitutes "inflation" is a difficult question in itself and answering a question about a phenomenon that is hard to quantify viscerally probably causes people to respond to surveys with an answer indicating what they expect the well-known CPI measure to show. I talked about many of these problems in my paper on measuring inflation expectations ("Real-Feel" Inflation: Quantitative Estimation of Inflation Perceptions), but the upshot is that we don't have a good way to measure expectations.

So, with that as background, consider this fact: next year, some Medicare participants will face a 0% increase in premiums while some Medicare participants will face increases of more than 50%.

I am skeptical of the notion of inflation anchoring. But I am really skeptical if it is the case that different segments of the population see totally different inflation pictures. Which anchor counts, if one large group of people expects 7% inflation and another large group expects 1% inflation?

I would argue that none of those anchors matter, because the whole notion is silly. Let's think through the mechanism of "inflation anchoring." So the idea is that when people expect lower inflation, they make decisions that tend to produce lower inflation. What decisions are those? If you expect 1% inflation, but Medicare costs go up 50%, what decision are you going to make that will cause that increase to be closer to your expectations? If eggs go up 25 cents per carton and you were expecting 5 cents...is the idea that no one will buy eggs and so the vendor will have to lower the price? What about his costs? Pretty clearly, the mechanism will have to work on the seller's side, but since every seller is a buyer except for the original seller of labor, the idea must be that if people expect high inflation they argue for higher wages, which causes prices to rise.

Aha.

I have put paid to that notion in this space before. It doesn't make any sense to think that wages lead inflation, for if they did then we would all love inflation because we would always be ahead of it. But we know that's not how it works - prices rise, and then we get higher wages. And sometimes we don't.

Let's try another hypothetical. Suppose the Federal Reserve literally drops $50 trillion, unexpectedly, from helicopters. And suppose that consumers did not change their expectations for inflation because they believed, much like the Fed does, that money doesn't play a role in causing inflation - in other words, their expectations were "extremely well-anchored." Does anyone think that the price level wouldn't change, a lot, in contrast to the expectations of the crowd? (I sometimes wonder if Lewis Carroll's Red Queen, who "sometimes...believed as many as six impossible things before breakfast," was a Fed economist.)

The whole idea that inflation expectations matter is an effort to explain why parameterizations of inflation models have a regime break in the early 1990s. That is, you can fit a model to 1970-1992, or to 1994-present, but you need different parameters for almost anything you try in the Keynesian-modeling world. Econometricians know that outcome means that you are missing an explanatory variable somewhere; econometricians also know that a very convenient way to gloss over the problem is to introduce a "dummy" variable. In this case, the dummy variable is explained as "inflation expectations became anchored in the early 1990s."

With all of the problems affecting the notion of expectations-anchoring, I find this solution to the modeling problem deeply unsatisfying. I do not believe that inflation expectations anchor for everybody collectively, but that different groups of people have different (and widely different) anchors. And I don't think that these anchors themselves play much of a role at all in causing a certain level of inflation. There are better models, simpler models, which do not require you to believe six impossible things.

Unfortunately, they do require you to believe in monetarism. And to some people, that is a seventh impossible thing.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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