Interest Rate Roundup

Tuesday, July 10, 2007

Ben's take on inflation

The text of Fed Chairman Ben Bernanke's speech in Cambridge, Massachusetts has been released. Most of the early part of the speech deals with how keeping inflation low promotes healthy economic growth. Nothing new there. Next, Bernanke tackled the topic of inflation expectations. He asks the following rhetorically:

"Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability. But what do we mean, precisely, by "the state of inflation expectations"? How should we measure inflation expectations, and how should we use that information for forecasting and controlling inflation?"

He then goes on to say that long-run expectations can vary depending on economic developments and the way monetary policy is conducted. He cites studies that "find that the sensitivity of inflation to activity indicators is lower today than in the past" and "that the long-run effect on inflation of 'supply shocks,' such as changes in the price of oil, also appears to be lower than in the past."

Then he gets into the fun part -- the part where he addresses food and energy prices and the implications for core inflation. Have a read ...

"Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent 'wage-price spiral.' With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices. A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on 'core' inflation, that is, inflation excluding the prices of food and energy.

"Although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored. A number of studies confirm that observation. For example, G├╝rkaynak, Sack, and Swanson (2005) found that long-run inflation expectations, as measured by the difference in yields between nominal and inflation-indexed bonds, move in response to news about the economy, rather than remaining unaffected. Levin, Natalucci, and Piger (2004) have shown that some survey measures of inflation expectations in the United States respond to recent changes in the actual rate of inflation, which would not be the case if expectations were perfectly anchored. Models of the term structure of interest rates better fit the data under the assumption that both inflation expectations and beliefs about the central bank's reaction function are evolving (Kozicki and Tinsley, 2001; Rudebusch and Wu, 2003; Cogley, 2005)."

Bernanke then goes on to post a bunch of questions to the academic community, whose general gist is "Help us figure out which measures of inflation expectations are the best?" After that, he talks a bunch about how the Fed tries to forecast inflation over the near-term and long-term.

All in all, it's pretty wonkish stuff -- interesting if you're a monetary policy nut, not so much if you're a trader or investor because the comments don't really directly address the current environment. We'll have to see if anything exciting comes out of the Q&A.

Incidentally, markets are basically unchanged from where they were before the text was released. Bond futures are up in price, down in yield, due to credit quality concerns, especially in housing and mortgage land. Stocks are down. And the dollar continues to get beaten like a rented mule.

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