An “Unsettling” Similarity to 1970s Inflation?

Well, at least the quality improvements of the iPad2 weren’t mentioned…

This paper by the San Francisco Fed’s Bharat Trehan, who, like most government economists has clearly drunk the Federal Reserve kool-aid, argues that Americans’ inflation expectations are unduly influenced by the rising cost of food (which they must buy in order to survive) and energy (which they must consume in order to travel back and forth to work) rather than the many low priced items we import from Asia.

This Economic Letter argues that the jump in household inflation expectations is a reaction to the recent energy and food price shocks, following a pattern observed after the oil and commodity price shocks in 2008. The data reveal that households are unusually sensitive to changes in these prices and tend to respond by revising their inflation expectations by more than historical relationships warrant. Since commodity price shocks have occurred relatively often in recent years, this excessive sensitivity has meant that household inflation expectations have performed quite badly as forecasts of future inflation.

Then again, maybe inflation, as calculated by government economists, does a poor job of reflecting what people actually spend money on, particularly at low income levels where food and energy make up a much larger share of their expenditures.

My uneducated guess is that if consumers at different levels of income or wealth were surveyed, you’d get a dramatically different picture of inflation expectations from the top to the bottom. Those whose food and energy expenditures constitute a relatively small portion of their overall spending would likely have their inflation expectations in line with the official measure of inflation, whereas, the growing number of people who struggle to put food on the table and gas in their cars would tell you that inflation in the U.S. is a lot like it is in Vietnam – about 20 percent.

Mr. Trehan goes on to note that professional economists are much better at predicting future inflation (presumably, in much the same way that foxes are good at watching hen houses), but he partially redeems himself by asking a few innocent sounding (and largely impenetrable) questions about 1970s style inflation.

At the same time, the high sensitivity of household inflation expectations to noncore inflation is puzzling. One could argue that this excess sensitivity reflects the fact that consumers buy things such as food and gas more frequently than they buy home furnishings or haircuts. In this case, expected inflation should come down relatively quickly because households will buy enough nonfood and non-energy goods at some point. It’s also possible that households’ sensitivity to noncore inflation goes up following substantial, sharp increases in the price of energy and food items, suchas those that occurred in the 1970s and over the past few years. This would be consistent with higher household sensitivity to noncore inflation at either end of our sample in Figure 2B. This similarity to the 1970s is unsettling because it suggests that consumers are not accounting for the ways monetary policy has changed over this period.

Maybe what they’re really accounting for is how the inflation calculation has changed…

Trehan should probably have a look at what St. Louis Fed President James Bullard has had to say about core vs. noncore inflation before he pens his next paper. From this report in Bloomberg earlier today:

Bullard, repeating a theme from a speech last week, urged that the Fed drop its focus on core inflation, which excludes volatile energy and food prices.

“The ‘core’ concept has little theoretical or statistical backing” and is very arbitrary, he said. “Headline inflation is the ultimate objective of monetary policy with respect to prices,” Bullard said.

Core, noncore, whatever. I’m just thankful we never had to see any “Whip Deflation Now” buttons.