One of the most misunderstood causes of inflation is in fact inflationary expectations. When people believe that there is going to be inflation, inflation itself tends to grow. This is not in any way a new concept. John M. Keynes came up with a theory, no longer widely accepted, which nonetheless deals with this issue. It's called the sticky wage theorem. Here's how it works. Suppose I am a worker. I believe that there is going to be inflation. To me this means that I cam going to be able to buy fewer goods. In response to this threat, I will go to my employer and demand higher wages. My demand of higher wages will in turn force employers to raise prices. In this way, because I feared inflation, I created it.

Inflation is a relatively misunderstood concept. By itself, it really isn't as harmful as many believe. Simply put, what it does is degrade people's savings and hurts people on fixed income. In an economy where prices rise 4% and wages rise 5%, the standard of living can still be rising. But what inflation does do, especially when it is unexpected, is to hurt productivity. When firms cannot make correct and accurate decisions because they are hampered by or unwary of inflation, they tend to delay investment and growth in productivity will generally slow. Currently, inflationary expectations have many important impacts dealing with the financial markets, which can cause inflation.

For example, when people expect inflation, two things happen to the bonds markets. First, lenders will demand higher returns on their investments. Because of the perceived risk, the borrowers will have to pay a higher return, which has to come out of their pockets. So what in effect happens is that firms like Dell and GM have to pay more to get funds. This slows investment and productivity and forces the firms to raise prices, again inflationary. Secondly, inflationary expectations can lead to a flight to quality. What this is, in essence, is a shift of assets from riskier to less risky investments. This would imply that someone who was averse to risky ventures, upon seeing their investments become riskier would put their money in safer places. This means things like purchases of government bonds will rise, but the new innovative start-up firms, the ones that can really increase productivity, will suddenly have a harder time obtaining assets.

From an international standpoint, inflationary expectations can affect the nominal exchange rate immediately. Because the inflation has not yet occurred, this change is in fact inflationary. So what does the credibility of the Fed have to do with all this? One answer is that a credible Fed will have much less difficulty controlling inflationary expectations. It also presents them with a much bigger palate of monetary policy options. Before Greenspan became Chairmen of the Federal Reserve, it was much more common for the central bank to make monetary moves of 50bp or more. During his leadership, the Federal Reserve has begun a policy known as gradualism.1 In effect, the FOMC moves interest rates in baby-steps. There are advantages and disadvantages to changing rates gradually.

As discussed earlier, one of the most important steps in controlling inflation is to control inflationary expectations. Gradual movements in the federal funds rate really aren't effective if the market doesn't think the central bank can control inflation. Gradual steps don't really say, "We're going to prevent inflation right now." As a compromise between larger shifts and the gradualist policy, the FOMC has taken to moving the discount rate in tandem with the Federal Funds rate. This has had the effect of adding an extra punch to their actions.

The other alternative of larger movements in interest rates has its own problems. Larger movements acknowledge problems in the economy and sometimes hope to shock the economy into correction. This method is sometimes the only viable alternative. It's not good for the economy to be shocked, because not only does it do damage in and of itself, but if it doesn't work there is a major loss of credibility in that the best efforts of the central bank were unable to control the country's woes.

What makes a central bank credible? It can be a combination of factors, but it really comes down to these few. The central banker himself must be respected. Before he became Chairman, Greenspan had been working on Wall Street and had been tracking the moves of the Federal Reserve, as well as the US economy. His work there had been stellar, and when he became Chairman he was well respected for his ability to control inflation. In several of his more recent speeches, he has been quoted as saying "in my more than half-century of observing the US economy..." This lends credibility by alluding to his multitude of experience.

Another way for a chairman to gain credibility is to be able to handle the economy in crisis. When the market feels that the central bank can control the economy even in crisis, it's long run expectations for inflation will fall. Greenspan has had his share of crisis. He has been chairman through the Persian Gulf War, the Asian Financial Crisis, the Brazilian collapse, the Russian woes, the Mexican Bailout of 1995, the credit squeezes, and more. However, there is evidence that in cases like this, too much credibility is dangerous. Investors can take really risky investments believing that if anything goes really wrong, the Fed will bail them out. The Federal Reserve has made it clear that it will avoid this whenever possible.

The current FOMC has been very open in their monetary policy. Their transparency has become accepted and expected by the markets. In his speeches, Greenspan has been forward enough to gain the term "Greenspanspeak," referring to his hints at the direction of monetary policy. When the central bank lets the markets know what they plan to do and why they do it, they gain credibility as well as timeliness. For example, when Greenspan speaks and hints that the economy is overheated, the market will react, acting as if the monetary contraction had already happened. This has the ability to smooth over transitions to different interest rates. Second, when the FOMC states that their number one goal is to control inflation, they increase the number of market participants that really believe they can do it.

A final factor influencing the credibility of the central bank is the track record of the Federal Reserve System. This includes the actions of the central bank and the level of inflation as well as the bank's ability to control the volatility of that inflation. A lower level of inflation is not necessarily as great a benefit as having inflation non-volatile. As mentioned earlier, one of the most harmful effects of inflation is that it hampers productivity growth. This is especially true when inflation is volatile because of the uncertainty of business decisions.

One of the current topics in monetary policy is inflation targeting. This means the central bank sets an acceptable level of inflation and attempts to keep the level close to this one. Often the suggested level is above zero, because there is always the fear of deflation or the economy becoming stuck in a liquidity trap. Inflation targeting is considered to be easier to enact than the targeting of monetary aggregates (the Fed targets the money supply now, aiming to keep the growth of M2 in the range of 1-5% annually.)

Inflation targeting has the double effect of increasing Fed credibility. If there is a target, the markets will expect this level of inflation and inflationary expectations will have less of an impact. Should the policy be successful, inflation should center around the target range and volatility.2  This would help to promote growth in productivity. Growth in productivity, at least in the long run, is anti-inflationary.

-Daniel Hicks
Economic Analyst
theshortrun.com 
  

1. Jones, David "The Politics of Money: The Fed Under Alan Greenspan", New York Institute of Finance, 1991 
2. Lars E. O. Stevenson "How should monetary policy be conducted in an era of price stability?" NBER Working Paper No. 7516 February 2000

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