There is near-consensus among advanced economies that the relatively independent central banks, in an operational macro-framework of inflation-targeting, have been successful in anchoring long-term inflationary expectations, thereby stabilising the inflation rate at around two percent, which helped these economies to operate in a minimal output gap over the business cycle. A key concept underlying these successes was the ability of central banks to convince different agents, e.g. consumers and producers, through persistent policy actions and effective communication and hence condition future expectations. A recent survey on inflation expectations in New Zealand, the first country to officially adopt such a framework, however showed that inflation expectations are not well-anchored even after 25 years. The same results emerged from surveys for the US. This raises the question if monetary policies structured to influence inflation expectations, e.g., inflation-targeting, are indeed effective. Commentators have already noted the relevance of these findings for India, where the evolution of household expectations is a continuous puzzle for RBI.
The focus of this column is upon more fundamental questions such micro-evidences pose about the success of inflation-targeting in the past two decades and the possible deductions that can be made about the framework in the light of changes in the post-crisis macro environment. The context is to understand the evolution of inflation expectations in some advanced countries, particularly the US where its central bank, the Federal Reserve is betting heavily to anchor inflation back to 2 percent from the zero bound as growth sustains, considerably closing the output gap.
It’s important to narrate the post-crisis developments that are inspiring researchers to examine public’s inflation expectations afresh through micro-surveys. This is the non-responsiveness of inflation expectations to central banks’ steady, prolonged attempts via quantitative easing—e.g. the Bank of Japan and more recently, the US Federal Reserve—to raise them from very low levels and thus lower real interest rates to stimulate economic activity when nominal interest rates were constrained. Deflationary pressures haven’t ended still however; in fact, these are currently a potent, rising threat to recovering economies.
In the US, as its central bank gets set to raise interest rates in response to progressive recovery of output, inflations have refused to rise. The five and ten-year Treasury “break-even” rates—the difference in yields of nominal and inflation-protected bonds that is a measure of investors’ inflation expectations—continue to slide down, notwithstanding the Fed’s monetary tightening hints. Likewise, consumers’ medium-term inflation expectations were at their lowest level since June 2013 as per the Fed’s September 2015 survey. In Japan, inflation expectations of firms and consumers have been weakening, testing the credibility of the Bank of Japan which wants to generate 2% inflation by raising inflation expectations.
Note, in both countries, the idea underpinning the bond-buying programmes was to influence the inflation expectations of agents, i.e. the perceived real interest rates, and produce real economic effects. That inflation expectations are moving in the wrong direction instead suggests that the strategies to trigger changes in inflation expectations are not having the desired effect. Whether this is due to an unaware public, inadequate communication by central banks, or other reasons is something that is best understood by assessing the knowledge and understanding of the public, whose pricing, hiring and investment decisions reflect the impact of the forward guidance monetary policy tool.
This is precisely what the Brookings* study does. Researchers Kumar et al asked wide-ranging questions of a group of firm managers in New Zealand about their inflation expectations and their awareness and understanding of monetary policy. To their surprise, they found that firms’ inflation expectations were not well-anchored, i.e., neither low nor stable. Firms’ inflation forecasts were at much higher levels than actual inflation had been, at both short-run and very long-run horizons; their average perception of recent inflation was also systematically much higher than actual inflation; there was tremendous dispersion in the forecasts at all horizons, and far more uncertainty in their inflation forecasts than observed in that of professional forecasters.
Equally, if not more, pertinent is that the survey found scant evidence that managers knew much about monetary policy, viz. who the central bank’s Governor was, whether inflation-targeting was its mandate, what was the inflation goal, and so on; very few tracked monetary policy reports, other information or communications from the central bank. When the researchers tested for answers from existing survey data on consumers’ inflation expectations in the US, they found that inflation expectations there seemed as unanchored; no one knew who the Fed chair was, were mostly unable to identify recent inflation behaviour or confidently predict low inflation 10 years down the line; consumers weren’t even interested in knowing about monetary policy.
The absence of links between formation of agents’ beliefs about current and future inflation dynamics and the central bank’s communications of its own intended actions and goals then suggests that monetary policies like inflation-targeting, which work via altering expectations are unlikely to be very successful, according to these authors.
The results thus challenge deep-rooted beliefs and evidence about the success of inflation-targeting. In conjunction with the post-crisis inflation developments discussed above, the question arises if the success of inflation-targeting in the previous two decades is more attributable to a very different macroeconomic environment?
Pre-crisis, this was characterised by developments of far-reaching significance—e.g. productivity shocks from inflation-targeting and entry of Chinese low-wage labour into the global pool, the expansion of world trade and output from China’s integration into the world economy, to name a few—that kept inflation globally low. The fact that inflation expectations have failed to adapt or respond in the reverse direction, i.e. upwards, when central banks have sought very hard and long to change these, certainly provokes doubt if the pre-crisis low inflation outcomes owed much to inflation-targeting and central banks’ achievements. If it were indeed so, then why have central banks been unable to alter expectations in a desired direction?
We conclude with recalling that in the post-crisis recession period, inflation has hardly budged, remaining stable despite the large shocks. A feature that was explored in some depth by the IMF two years ago (The Dog that didn’t Bark: Has Inflation been Muzzled or was it just Sleeping?, World Economic Outlook, April 2013). The IMF’s conclusion was that the sharp decline in output post-crisis did not spillover into a wide spread deflation in advanced economies like in the 1930s because expectations remained well-anchored, close to central banks’ inflation targets; a further argument was that inflation would claw back to two percent as the negative output gap closed with quantitative easing.
But less than two years down the line and the evolution of inflation expectations since, doubts have sprung and queries are being raised on the claims of the framework. The Federal Reserve chairman, Janet Yellen, was almost compelled to deliver a long speech at MIT on September 24, 2015, seeking to reassure the market on its belief that nothing structurally, as yet, has undermined long-term inflationary expectations, and that inflation would eventually return to 2%in the next 2-3 years. But the wait has been too long. And studies such as the one cited above, which question long-held beliefs on the framework, could create fresh uncertainties if inflation continues to be lower or even begin to move further down. In line with the IMF’s analogy, if the dog indeed wakes up to bark, what would Sherlock Holmes make out?
*Inflation-targeting does not anchor inflation expectations: Evidence from firms in New Zealand, brook.gs/1MBu3Tv
The author is a New Delhi-based macroeconomist