This week Janet Yellen experienced a classic New York ritual: she addressed the Economic Club of New York about monetary policy, speaking with a sense of solemn tradition. An audience of economists and investors hung on her every word about growth and interest rates, and concluded that the signals from the US Federal Reserve were growing more dovish about future rate rises.
The most thought-provoking part of the speech, however, was when the Fed chair admitted to being “baffled” by current inflation expectations. The US central bank keeps a close eye on the University of Michigan survey of consumers and on the movement of prices in the Treasury Inflation-Protected Securities market. The assumption is that the expectations of investors and consumers could be self-fulfilling - unless the Fed persuades them that prices will rise to a reasonable level, and then stay stable, inflation or deflation might spin out of control.
Since early 2014, the level of inflation expectations expressed by the Michigan survey and Tips market has fallen sharply. The survey suggests consumer inflation expectations are for 2.5 per cent inflation in one and five years’ time; in 2011 it was 4.5 per cent. Thankfully, expectations have not tumbled to levels that look dangerously low and the Michigan survey suggests consumers still expect prices to rise rather than fall.
But the decline is odd given that the economy has been expanding and that core consumer price inflation has risen slightly. This week the US Department of Commerce said domestic inflation - measured by the core rate on personal consumption expenditures, the Fed’s preferred inflation gauge - grew 1.7 per cent in February on a year-on-year basis, its highest level for three years. And Fed officials such as Ms Yellen keep telling the public that core inflation will rise in future to stable levels.
So what explains falling inflation expectations? One answer might be that investors and citizens are indeed more pessimistic about the economic outlook than the Fed, and have lost faith in the central bank’s ability to push prices higher using extraordinary monetary policy tools.
A second possibility is that the data on inflation expectations are distorted. Ms Yellen, for example, suggests that “market-based measures of inflation expectations”, such as Tips prices, are “driven by illiquidity concerns”. In plain English, she means that trading in the bond markets is so log-jammed that they are emitting false signals.
Another widespread theory is that the recent collapse in oil prices has affected the Tips market and the Michigan survey in peculiar ways. As Rick Rieder of BlackRock observes, falling energy costs have a disproportionately big impact for low-income households, and this might be skewing surveys about the path of inflation.
Both of these explanations probably contain some truth: consumers are more fearful about the economy than the Fed and are influenced by energy prices.
Technological shifts may also be changing the way in which consumers imagine prices. In the mid-20th century, western countries presumed consumer goods prices would rise over time and that wages, too, would increase throughout people’s lifetimes. These assumptions no longer hold true. The cost of products with high cultural value and status, such as iPhones, tends to fall, not rise. And, as traditional employment structures unravel, consumers are learning that wages can also fall with age. Consumers do not see prices in a straight line of “inflation” and “deflation”, as economists are apt to do, but rather as something fluid and volatile.
Perhaps this is the crucial point: what we need is not just economic analysis of price trends but on-the-ground ethnographic analysis of how consumer perceptions of prices operate. Scandinavian central bankers have looked at the social context of price trends, while last year the Fed published an intriguing paper on “ Consumers’ Attitudes and Their Inflation Expectations”. This suggested consumers predict higher inflation when their household finances are under pressure and when they read media discussions about inflation.
If the Fed, or any central bank, wants an illustration of why ethnographic research matters, they need only look at the last credit bubble, when most economists missed the subprime mortgage boom because they shunned on-the-ground research.
Fed officials need to get into consumers’ lives. Or else hire a few anthropologists to work with those office-bound, and baffled, economists.
