The paper summarized here is part of the fall 2021 edition of the Brookings Papers on Economic Activity, the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. Research findings are presented in a clear and accessible style to maximize their impact on economic understanding and policymaking. The editors are Brookings Nonresident Senior Fellow and Northwestern University Professor of Economics Janice Eberly and Brookings Nonresident Senior Fellow and Harvard University Professor of Economics James Stock. See the fall 2021 BPEA event page to watch paper presentations and read summaries of all the papers from this edition. Submit a proposal to present at a future BPEA conference here.
Monetary policymakers trying to judge whether elevated inflation this year will persist should—heeding past lessons from the United States and abroad—carefully track inflation expectations, suggests a paper discussed at the Brookings Papers on Economic Activity (BPEA) conference on September 9.
A. W. Phillips Professor of Economics - London School of Economics and Political Science
The author—Ricardo Reis of the London School of Economics—examined the expectations of consumers, professional forecasters, and markets for inflation in the United States during the late 1960s and early 1970s (when inflation started climbing), during the early 1980s (when inflation stabilized), and during the COVID-19 pandemic. He also looked at episodes in Brazil and South Africa between 2010 and 2016, and in Turkey after 2017.
“If expectations of inflation rise, households will buy more goods today, savers will shift away from nominal assets [such as bonds], workers will demand higher wages, and firms will post higher prices, all of which lead inflation to rise,” he writes in Losing the inflation anchor. And he warns, “if expected inflation rises, then only a deep recession can keep inflation down.”
He compared trying to anticipate future inflation to sitting on a beach trying to figure out, before it is too late, if a boat is drifting away from shore, and likened inflation expectations gauges to “a grainy picture of the boat’s anchor.”
After examining expectations data for last year and this year, he concludes “the jury is out on whether inflation is going to drift away.” He finds reasons for some concern from household surveys but says monetary policymakers still have time to respond.
The paper begins by focusing on the U.S. experience between 1965 and 1974. Current widely used gauges of expectations, such as the monthly University of Michigan Surveys of Consumers and inflation-indexed Treasury securities, did not exist then.
However, Reis looked at rarely used data, including a short-lived quarterly precursor to the Michigan surveys and the gold futures market in Zurich, Switzerland. He concludes that expectations for U.S. inflation began rising as early as 1967. Had the rise in expectations, and their importance, been recognized earlier, Fed policymakers might have considered acting more forcefully to damp inflation. The Fed did not bring inflation, and expectations, under control until, under Chair Paul Volcker, it undertook highly restrictive monetary policy between 1979 and 1983.
In more-recent episodes, policymakers in Brazil, observing that inflation in 2010 was on target, sharply cut interest rates in 2011. But inflation was restrained only temporarily because of government controls on gasoline and diesel prices, and expectations became unanchored between 2011 and 2016. In Turkey, political pressure on the central bank by President Recep Erdogan in the run-up to elections had, by the end of 2017, unmoored inflation expectations. Actual inflation surged in 2018 and 2019.
South Africa between 2010 and 2016 offers a counter example. Actual inflation pushed to the upper bound of the central bank’s target, but—citing temporary shocks to food and electricity prices—it did not sharply tighten monetary policy. Data shows that expectations remained anchored, and inflation subsided.
Reis writes that it is too soon to tell whether inflation expectations in the United States are drifting away now, as they did in the late 1960s, or whether they will remain anchored despite temporary shocks to key prices, as they did in South Africa. Professional forecasters have only slightly raised their inflation expectations for the United States. Market expectations have moved significantly higher this year but only after falling in 2019 and 2020. Household expectations, however, have jumped up faster in just six months than almost any time since the 1980s.
“Inflation is going to be quite high in 2021. Whether it is a short blip or whether inflation will get out of hand depends on expectations, and there are some worrying signs in the data right now,” he said in an interview with The Brookings Institution. “Ultimately expectations depend on what policy will do in the next few months: Will the FOMC let the anchor drift or not?”
Reis, Ricardo. 2021. “Losing the inflation anchor.” BPEA Conference Draft, Fall.
Conflict of Interest Disclosure
Ricardo Reis’ research is supported by a 5-year grant from the European Research Council. Other than the aforementioned, the author did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. They are currently not an officer, director, or board member of any organization with an interest in this article.
David Skidmore authored the summary language for this paper. Becca Portman assisted with data visualization.