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Carola Binder on the Importance of Inflation Expectations and How Policymakers Should Respond
It remains crucially important for the Fed to properly manage inflation expectations, but in this exercise, actions speak louder than words.
Carola Binder is an associate professor of economics at Haverford College and is currently a visiting scholar in the Monetary Policy Program at the Mercatus Center. She is also an associate editor at the Review of Economics and Statistics and the Journal of Money Credit and Banking. Carola rejoins Macro Musings to talk about inflation expectations and uncertainty. Specifically, David and Carola discuss why we should care about inflation expectations, which survey measures are most important, how policymakers should respond, and more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]
David Beckworth: Carola, welcome back to the show.
Carola Binder: Thanks, David. It's great to you back.
Beckworth: It's great to have you on and it's great to have you as a colleague for this season while you're with us. And you've been very productive, a lot of interesting policy briefs. We'll touch on some of them as we get into the show and I know you've had a busy summer. You've been at the NBER Summer Institute, is that right?
Binder: That's right. I was there for a week in the middle of July for the monetary economics workshop. So that was a lot of fun. And then I also gave a panel presentation the following week for the household finance group. So that's always a great thing to go to in the summer to get to really see a lot of recent research, catch up with a lot of people. Yeah. So I had a good time.
Beckworth: And connect with the big dogs of monetary policy. Right?
Beckworth: Yeah. Conferences are as much about networking as they are about learning. I mean, I think it's important we learn and we see new research, but also to meet and visit with old friends and make new ones. And it's great that you're doing that and we're glad to have you here at Mercatus. And today we're going to talk about inflation. It's a hot topic, but before we do that, Carola, let's talk about your work at Haverford College. You're a macro economist, you're at a liberal arts school. There might be graduates out there who are maybe thinking about going down this career path. What would you tell them about your experience at Haverford?
Binder: Yeah. I'd love to talk to people about that. When I was in graduate school, honestly, I wasn't even that aware of liberal arts colleges. I went to undergrad at Georgia Tech and then grad school at Berkeley, which are both big public universities. And I didn't really know that much about liberal arts colleges, but when I went on the job market, as most people do, I just applied really broadly. And I ended up with what I thought was my best job offer was from a liberal arts college. And it's actually been a great experience. You kind of wear a variety of hats when you work at a liberal arts college as an economist. You teach a lot. So I have a 3:2 teaching load, which means I'll teach three classes one semester, two classes another semester. It's all undergraduates there.
Binder: So there's no PhD students or grad students. So I'm teaching undergrads. I'm also advising several undergrad senior thesis projects each year. I do different kinds of other service for the college like I'm the faculty liaison for the women's cross country and track team. I'm on a couple of different committees. And then of course, I try to do research at the same time. So liberal arts colleges being small, they have smaller economics departments, which means that right now I'm the only macro economist at Haverford. So if I do want to collaborate with people on research, I have to try to go to conferences, do the kind of networking and meet people from other places. It's been pretty good because Haverford is in a good location for doing that. I'm in Philadelphia, so I can get to DC or New York, or just about anywhere pretty easily, and also meet with coauthors over Zoom. So, it's been a good experience. I think I've still managed to get a lot of research done and I felt like I've had a lot of flexibility to focus on whatever I want to, as far as research. So it's been good.
Beckworth: So you mentioned you've got a lot of research done and that's an understatement. You've been very prolific. And I'm just wondering, how do you balance that? How do you pull off all that research that you've done and have a 3:2 teaching load?
Binder: Well, I do work a lot over the summers and over sabbaticals on getting research done. So some of the teaching that I do is introductory level courses, but I also get to teach some electives and I try to keep them related to my research. And I try to update the reading list with things that I want to be reading and thinking about anyway. And I live on campus. That's actually a big help because then I don't have any commute time. So it saves me time. I can easily run over to my office, meet with a student, run over and teach a class, get back home as I need to. And I think that just having a lot of different demands on my time, I try to be deliberate about planning what I'm going to do and when I'm going to do my research.
Beckworth: So you're smart, careful, and efficient with your time. And as a [inaudible]…
Binder: I try to be.
Beckworth: ... you put out a lot of research out. So that's why you get invited to the NBER Summer Institute. And you publish in good journals and have a lot of interesting work. And you're an expert in this area of inflation, inflation expectations. And we're delighted to have you here at Mercatus-
Beckworth: ... and be a part of our program. And I should also mention that Carola is a big fan of nominal GDP targeting. So that's also a plus in my assessment. Let's talk about inflation. And I just want to highlight some facts that all of our listeners know. In the US, our last inflation reading came in at 9.1% headline CPI. We know the Fed tracks PCE, but it's the headline number that matters. In Europe, the headline equivalent measure, the CPI was 8.6. They're pretty close to 9% as well. The BIS had an annual economic report this year, which I found interesting. They talked about the inflation problem around the world and they noted that it's not just the US or Europe. It's a lot of advanced economies and emerging markets that have this acceleration of inflation. In fact, if you look at their numbers, you look at what's happening in the US and Europe, there's been about a year and a half of accelerated inflation, not just a one time pop, but it's been going up, up and hopefully we're going to see a turnaround here soon, but they had some interesting statistics I wanted to share. So they looked at the share of countries that have greater than 5% inflation. And for advanced economies, it was 85%. So almost all of the advanced economies are having inflation greater than 5%.
Beckworth: Emerging market economies, it was 64%. And then they had another interesting statistic where they looked at, okay, so we have all these countries greater than 5%, how widespread or diffused is that inflation? Maybe it's just oil or some particular sector. And they found that in terms of the consumer basket, what share of it is greater than 5%... for advanced economies, it's around 50%, emerging markets, 70%. So in other words, 50% advanced economies, the consumer basket, the diffusion, the widespread part of it that's going up was half of the advanced economies and about 70% of emerging markets. So it's not just an acceleration. It's widespread and it's problematic. And we haven't seen anything like this in a long time. Now, I know emerging markets have had high inflation, but even relative to their past record, it's higher. It's more problematic. And I want to get into why does this matter so much to people? Why do we care so much? And to motivate that, I want to read an excerpt from a Gallup article that was written in June by Frank Newport and the title of the article is, *How Do Americans View Higher Inflation?* And the article starts out with a couple of points he builds up on. And his first point is, “worry about inflation has now risen to the point where it is perceived by Americans as the top problem facing the nation.”
Beckworth: And then he goes on to explain. He goes, "As my Gallup colleague, Jeff Jones, recently reviewed, mentions of inflation as the most important problem facing the nation average only 1% between 1990 and 2021, but such mentions zoom to 18% in our latest May Gallup poll. Inflation is thus now essentially tied with issues relating to the way the nation is being governed as the top problem facing the nation. In April, we asked Americans about their personal financial situation, inflation dominated America's thinking." And they go on to mention it's above the Russia Ukraine war, climate change, COVID, immigration, racial inequality, abortion, and they list a number of polls that show inflation is this number one issue, given everything else going on in the world, which is pretty surprising. And so maybe we can start there. Why do you think households care so much about inflation?
Why Should We Care About Inflation?
Binder: Yeah, that's a great question, and there's a lot of different reasons. Partly, it is hard to separate it from what you call everything else going on in the world. One of those other options was the war, healthcare. People might have those in mind when they say that inflation is the number one problem because they see high inflation, and this is a signal that to them, that everything else is going wrong or that some things are going badly wrong, if people don't necessarily know where the inflation is coming from, but they know it can't be coming from something good, something's out of order. The other thing, I mean, it does have a big effect on people, on their finances. Usually when [there’s] high inflation, people also get higher wage and salary increases, but it's not necessarily going to be the same and it's not going to be at the same time.
Binder: So they're not sure how much their real income is going to change, how much their real wealth is going to change. You could imagine, okay, if all prices rose by 10% and all wages and salaries rose by 10%, maybe it wouldn't be that bad, but it's not just that wages and prices might not be rising the same amount. It's also that different prices are not rising the same amount. So when we have higher aggregate price changes, we also usually have higher dispersion in these price changes for underlying goods and services. So there's going to be relative price changes, which are really hard to keep track of. So you go to the store, you see that something that you're planning to buy is more expensive. Is it because of inflation or is it a relative price change? And that gets harder to tell the higher inflation is. And so then it gets harder to plan, harder to be strategic about what you're going to buy. And it's harder to predict what's going to happen in the future. So when you're trying to budget, it just makes it a lot more uncertain and a lot more stressful for people.
So you go to the store, you see that something that you're planning to buy is more expensive. Is it because of inflation or is it a relative price change? And that gets harder to tell the higher inflation is. And so then it gets harder to plan, harder to be strategic about what you're going to buy. And it's harder to predict what's going to happen in the future.
Beckworth: Yeah. I had a professor who used to say inflation pollutes the price signal, that the information you can glean from a relative price change, if certain food items go up… is it because all prices are going up or because that particular item is more scarce? Maybe I should substitute out of it into something else. So that's a great point. Now I want to go back to something you mentioned initially that some people are using inflation maybe as a proxy for all these other problems. And I noticed that recently in terms of the discussion surrounding inflation, I had some friends who were watching certain network news and they were just besides themselves. How can you say there's not a recession, how can you say things are okay? And what they invoked was actually inflation. I'm like, "That's inflation. That's not decline in real economic activity." But they conflated the two. And I had multiple people tell me this, and I understand, you're real earnings are going down, but is that common for people to conflate inflation with other poor economic outcomes?
Binder: Yeah, it's very common. I mean, partly it is, sort of, economists are to blame in that we haven't given people a clear enough explanation of what a recession is. And we have this NBER that decides, and we kind of tell people the economists decide when it's bad enough to be in a recession. And so inflation is really bad, so that seems like a recession. There have been some big recessions in the past that had also high inflation. So the stagflation type episodes, I think people really have those in mind when they see high inflation or when they see a recession. They then expect that there's going to be high inflation because they think of those bad things going along together. I have a paper about this. It's not so much about inflation as it is about gas prices specifically, but when people see gas prices rise, then they assume that that's bad news about the economy in general, especially if they were old enough to remember the late 1970s, early 1980s, when you had high oil and gas prices at the same time as a recession.
Beckworth: Is there a linear relationship or is it more painful going up than say, I don't know, the calm or reassurance you get when it comes down for consumers?
Binder: In that particular study that I did, the data series I was using wasn't long enough to really be able to statistically distinguish whether there was any asymmetry like that. I assume it probably would be. And the reason I think that it probably would be is because of the media actually, where bad news tends to be more newsworthy. It gets reported on more. So people tend to be more aware of high inflation and of rising gas prices than they are of the opposite. I mean, at some level of inflation, you notice it whether or not it's making the headlines, but if you're just going on what you read in the newspaper or see on the news on TV, I think you're going to be getting a lot more of people telling you that things are bad when inflation is rising and you're not going to get people telling you, "Look, gas prices are falling," or, "Look, inflation's lower. Things are great now." That's just not considered a newsworthy story.
Beckworth: So another point you made is that inflation affects everyone. It's something everyone sees. And it's always struck me as interesting, this point, because we've talked to people for example, about the Great Depression in Germany. So in Germany, in the 1920s, they had the hyperinflation, but they also had the Great Depression, and today Germany is known as the anti-inflation hawk world. They drive the more hawkish side of the ECB and the Bundesbank before it. And I've asked people, why do the Germans remember the hyperinflation more than the deflation of the Great Depression? And the answer I get is well, because everyone felt a hyperinflation. When you're in a recession, some people do become unemployed, but not everyone. So it's more pervasive. Is that I think a reasonable understanding of why it's so widely hated?
Binder: I think that's reasonable. And I think that, well, the hyperinflation was just orders of magnitudes more than any kind of-
Beckworth: It's fair.
Binder: ... deflation. The question… would people remember 5% inflation the same as they would remember 5% deflation, that's a little more questionable, but I think a hyperinflation is just ... I mean, that's such an extreme event and such a devastating event that I think that's going to be by far the most salient-
Beckworth: It's lasted a long time, right? I mean, here we are 2022. So another potential story here as to why people hate inflation so much, and you have research on this, is not just that inflation's high, but the uncertainty, like you don't know how high it's going to go. And I've looked at the New York Fed, they have a nice little webpage you [can] interact [with]. And it shows inflation forecasts for households, similar to the University of Michigan's forecast, but they also show uncertainty and you've helped me understand it because it's a little confusing. But what you see is that both inflation expectations have gone up, but the uncertainty surrounding those have gone up and they've gone up the most for the lower income households, which is pretty interesting. So tell us about the work you've done on this. In fact, you have a policy brief, I believe, you're writing for us on this. So how important is the uncertainty versus the actual inflation rate?
The Importance of Inflation Uncertainty
Binder: Yeah, so there's two main surveys that we use in the United States to study consumers' inflation expectations. One is the Michigan survey, and that has been getting numerical point forecasts of inflation from consumers since 1978 every month. And then there's a newer survey that you mentioned by the New York Fed. That's the survey of consumer expectations and that New York Fed survey, instead of just asking for a point forecast, so what number do you think inflation will be? They ask for what's called a density forecast. So they're trying to get at people's whole probabilistic view of what inflation will be over the next year and then over a two to three year horizon. So they ask people for probabilities that inflation will fall into various bins. What do you think is a chance that inflation will be less than negative 12% or negative 12% to negative 8%?
Binder: And there's these different ranges and people put probabilities in there, and those need to add up to 100%. And then that's like a discrete probability distribution. So the New York Fed staff then have this procedure they use to fit a smooth probability distribution onto that. And they calculate the interquartile range of that distribution. So it's a measure of how wide it is. So if you have a bigger interquartile range, there's more spread between what you think is a possible low outcome for inflation and what you think is a possible high outcome. So they use that as a measure of consumer's uncertainty about future inflation. If you're 100% certain that inflation is going to be 2%, then your interquartile range is zero, right? You would be perfectly certain, but people are not perfectly certain. So there's this different interquartile range for different people.
Binder: And that's the measure that has been rising, but that survey only started in 2013. So we can see that it's been rising, but it's hard to say in historical perspective, how big is that increase in uncertainty? So a couple years ago, actually, while I was in grad school, I wrote a paper that was trying to measure uncertainty from the Michigan survey, since it's available for so much longer. And that survey doesn't actually ask people for a probability distribution over inflation. But what I noticed was really common occurrence was that when people give their point forecast, they tend to give multiples of five percentage points. So they'll say inflation will be 5% or inflation will be 10% or 15%, a lot more than they'll say inflation will be 4% or 6% or nine or 11. And of course some people do say inflation will be 2% or 3%, but then you get these spikes at the multiples of five. So I came up with this method that uses that rounding behavior to make a proxy for inflation uncertainty.
Binder: And so that gives me this inflation uncertainty index that's available monthly since 1978. And I have it at two different horizons because they're asked about inflation one year from now, and then five to 10 years from now. And what you see is that inflation uncertainty declined with inflation during the Volcker disinflation. So as inflation itself fell, people became more certain about what inflation would be in the future. And the other interesting thing is that uncertainty about longer run inflation actually fell lower than uncertainty about shorter run inflation. So even when people get uncertain about what's going to happen to inflation in the next year, they still feel pretty confident about what it's going to do over the longer term. And that itself is a good sign for the Fed, for expectations anchoring, because it suggests that even if there's some kind of short run shock that people think is going to affect short run inflation, people still feel like, "Well, it's going to go kind of back to normal if you give it a couple years."
Binder: So in 2020, when the COVID pandemic hit, there was a huge spike in short run inflation uncertainty, and a much smaller one in long run inflation uncertainty, and then short run inflation uncertainty actually started falling back down. When inflation itself started rising in 2021, we get inflation uncertainty rising at both horizons. Again, more so for the shorter horizon than for the longer horizon. But we do see over the last couple months, the steady increase in longer run inflation uncertainty. And that's the increase that I think is more troubling because it's saying even in 5 to 10 years, people are becoming less sure about what's going to happen with inflation. Now for the period from 2013 to now, my inflation uncertainty measure and the one derived from the New York Fed's data are very similar. So that gives me a lot of confidence that this rounding behavior is actually a good proxy for uncertainty. And the other kind of good news perhaps is that even though long run uncertainty is steadily rising, it's still not anywhere near where it was in the in early 1980s. So we're still not up to that level of inflation uncertainty about the long run. So hopefully it will just start to fall as hopefully inflation starts to fall, but I'll just keep updating those indices and probably tweeting about them and maybe occasionally writing policy briefs about it.
For the period from 2013 to now, my inflation uncertainty measure and the one derived from the New York Fed's data are very similar. So that gives me a lot of confidence that this rounding behavior is actually a good proxy for uncertainty. And the other kind of good news perhaps is that even though long run uncertainty is steadily rising, it's still not anywhere near where it was in the in early 1980s. So we're still not up to that level of inflation uncertainty about the long run. So hopefully it will just start to fall as hopefully inflation starts to fall.
Beckworth: Yeah, really interesting work. And thank you for the reassuring hope there. We're not yet 1970s, early '80s level of uncertainty, but also we shouldn't rest too comfortably. The Fed has this job cut out for it to make sure that that uncertainty comes down. Going back to this observation made earlier that the BIS… they provided this data across advanced economies and emerging markets and they liked this 5% number. They picked 5% inflation as this threshold. So they asked again, what percent of advanced economies have inflation above 5%? It's like 85%, so most advanced economies. And then they ask what percent of the consumption basket, all the items, is above 5%? And that number is growing too. Is there something magical about 5%, do you think from the literature?
Binder: A little bit. I mean, from the paper I just told you about when people give their inflation expectations, they do give multiples of 5%. So I think people might not distinguish between 3% inflation versus 4%. Those are just kind of small numbers. Then 5 is a medium number, 10 is big, right? They would give these round numbers, but I don't think that there's anything magical that if the CPI is 4.9 or five, that people somehow notice it more at five. But what I do think again is back to the media. So the media might be more likely to start really reporting it when you hit a round number. This would actually make a good research project for someone out there to go around the world and see how much media reporting there is on inflation releases when they are just below, just above, different thresholds.
Binder: I think certainly if we get, I'm not predicting this, but if we get a 10% CPI release, that's just going to really explode the media coverage. So yeah, I could see where there would be something about a 5% threshold, a 10% threshold, but I think it would be really coming from the media because the inflation that people are experiencing is going to vary a little bit for different people. So even if the CPI is 5%, some people's consumption basket is going to increase by less than that. And some people's going to increase by more than that. So if they're not following the numbers, there's nothing special about five. It's only if they actually become aware of the official statistics, that there would be something.
Beckworth: They start paying attention after five. That's kind of the takeaway got from the BIS is that after 5%, people start actually paying attention to the price level, to CPI. Underneath that, they're kind of like ... it's a relative price change. They don't use that term, it's relative price change, but they say, "Milk's more expensive for whatever reason." But after 5%, somehow people begin to be more aware of this whole inflation process. And you're saying maybe it's media driven, partly.
Binder: Yeah. And I think for the prices of specific goods, like gas and milk, then there's also threshold effects. But marketers know that and so they price things accordingly. And that's why you get a lot of prices ending with 99, 3.99. But when gas prices go above four, above $5 a gallon, then people are more likely to notice that. But people selling are going to try to keep it below the threshold as long as they can.
Beckworth: Okay. Well, let's talk a little bit more about measuring inflation expectations. So we've touched on why people dislike it so much. And you've already mentioned two of the household or consumer side of inflation expectations, the University of Michigan, the New York Fed. Are there other surveys of households that's worth mentioning?
Diving Deeper Into Inflation Expectations
Binder: There are. There's kind of this proliferation of household surveys that are coming out. One is that just in other countries, other central banks have been starting their own surveys. The Bank of Canada started a quarterly survey, but it's very much like the New York Fed survey other than the fact that it's quarterly. The Cleveland Fed has some really interesting work. There's at least two new surveys that they're running that I know of that are at higher frequency. I think one is daily and one is weekly. And they also ask about inflation in a different way. I think one of the surveys asks, “what do you think is the effect of COVID on inflation?” So it's called COVID impact on inflation survey or something like that. And I think the other one… it asks something along the lines of like, “what increase in your salary would you need to be able to keep up with inflation?”
Binder: So there's this interest in seeing like, "Okay, if we ask the question differently, are people going to give us maybe some answer that's a little more meaningful?" Because you start to wonder when you look at say the Michigan survey and people are giving you inflation expectations of 10%, not this year, but a couple years ago when we had not had anything like that for so long, you start to wonder if they're really giving you what you might call their true or their underlying inflation expectation. So I think there is interest in asking the question different ways. People are interested, especially at central banks, in starting their own surveys so that they can tack on extra survey modules or little experiments within the surveys to try to get more causal understanding of the drivers of inflation expectations and of the consequences of inflation expectations on consumer behavior. So those Cleveland Fed ones are two that I'm aware of. And I'm sure that there are others. And then there's also researchers just doing their own sort of one-off surveys. I've done a couple of these myself where you design and launch your own survey, but maybe you only do it once or twice rather than doing it at some regular frequency.
Beckworth: Now didn't you have a major professor at Berkeley who's done some of these same surveys?
Binder: Yes. So my advisor at Berkeley was Yuriy Gorodnichenko, and he and his co-author Olivier Coibion and several other co-authors have done a lot of their own surveys. They've worked with some of the major survey companies, like I think Nielsen and some others where they can really get a huge sample. They can sometimes tack on an inflation expectations component to an existing survey that maybe gets information about what people have purchased. And sometimes there's a sample of thousands of people, so they can provide a lot of different randomized information treatments, and then see how expectations in the control group compare to expectations of people who are told something about what inflation has been or something about the Fed's policy. And they've done a lot of these. They did some around the time that the AIT was announced, the average inflation targeting framework was announced. And yeah. So they've been-
Beckworth: What'd they find? I'm curious, what did they find? Any big [inaudible]?
Binder: I think they found that as you might expect, consumers were not quickly aware of a major change in Fed policy and even if they had heard some news about it, they didn't really know what to make of it as far as changing their inflation expectations.
Beckworth: Yeah. So that's the question I was going to ask. And you touched on it. Kind of the difference between consumers, what they state on a survey versus what they actually do, kind of a revealed preference. So you mentioned they actually have data on spending choices. And I've come across an article here, *Inflation Expectations in Consumer Spending: The Role of Household Balance Sheets* by Lenard Lieb and Johannes Schuffels, if I'm saying their name right. And they actually had access to household spending decisions. I believe this is in the Netherlands, but somehow they got data on household balance sheets as well as inflation. So you can kind of see they say one thing, do they actually act upon it? I mean, is there a lot of that going on?
Binder: There are a lot of studies along these lines that try to, I mean, answer the question of, okay, if somebody's inflation expectations change, how does that change their behavior? And this literature really started exploding during the Great Recession when the federal funds rate was at the zero lower bound, because when you get to the zero lower bound, then the central bank can no longer just change nominal interest rates as its policy lever. So instead if it wants to try to stimulate the economy, one possible route that it can go is trying to change inflation expectations. Because if you raise inflation expectations, then you're lowering the real interest rate, even with the nominal interest rate held constant. So whether or not this can be effective, depends on two parts.
Binder: One is, can the Fed or can any central bank actually actively change people's inflation expectations through communication? And the second part is, do those changes actually then affect their consumption behavior in the way that economic theory would predict or the way that the central bank would hope? So, one of the early papers that looked at that second question was by Rudiger Bachmann. And it was Bachmann, Berg and Sims, I think 2015 in the AEJ macro. And they use the Michigan survey, which again, asks about inflation expectations. And it doesn't ask people what they spent or what they planned to spend, but it asks them this question, “do you think it's a good time to buy durables or do you think it's a good time to buy a car?” So they use that as their outcome variable and they regress it on inflation expectations and a variety of control variables.
Binder: And they find, if anything, a very, very small effect. So it didn't really look like that people with higher inflation expectations were rushing out to go spend money more quickly than people with lower inflation expectations. But a lot of other studies since then have tried using different surveys that maybe instead of asking this readiness to spend question, which is a little bit ambiguous, finding surveys that actually include questions about how much you have recently spent and/or how much you expect to spend in the near future. So if your inflation expectations rise, what you might think would happen is then you would want to buy sooner rather than later. So you might have spent more in the recent past and expect to spend less in the future.
Binder: Again, though there's been a lot of mixed evidence in the literature, a lot of either small estimates, sometimes people find a positive effect. Sometimes people find a negative effect or they find a really not very robust effect. So then I think the paper that you mentioned, that's more recent, I think people have tried to understand, okay, why are we not finding much of an effect? Is it that maybe people are unable to shift their consumption around when their inflation expectations change because they are liquidity constrained or constrained in some other respect. So I think that the paper that you mentioned maybe is following along those lines, but yeah, there's been a ton of work in this area. I think it's still ongoing. It's still a very open question. And I think one of the challenges with a lot of macro questions is the causality issue.
Binder: So if you're just looking in the cross section you have some households who think inflation's going to be high and some who think inflation's going to be low, that's probably not random. And you can control for demographics and other characteristics of the household, but there's still something about some households that makes them say a high number on the survey that might be related to what they're going to say about their spending, where we can't necessarily say that the inflation expectations caused or didn't cause the spending response. So you need some kind of natural experiment or some kind of instrumental variable or something like that.
Beckworth: That's hard, I guess.
Binder: It is hard.
Binder: I mean, people are definitely working on it, but I think the fact that we don't see really, really strong evidence in the cross section or in these panel data studies saying, "Yeah, people definitely shift their consumption intertemporally as their inflation expectations change," tells us, I think, that this is probably not a very easy policy lever for central banks to use. So at the zero lower bound, I don't think they should be really confidently relying on being able to change inflation expectations as a policy tool to affect the general public's consumption.
I think the fact that we don't see really, really strong evidence in the cross section or in these panel data studies saying, ‘Yeah, people definitely shift their consumption intertemporally as their inflation expectations change,’ tells us, I think, that this is probably not a very easy policy lever for central banks to use. So at the zero lower bound, I don't think they should be really confidently relying on being able to change inflation expectations as a policy tool to affect the general public's consumption.
Beckworth: So I get from that, you think there's enough evidence to reach that conclusion that maybe managing inflation expectations isn't all that important versus we just don't have good enough measures yet to reach a conclusion.
Binder: Yeah. But I mean, to clarify it a little, I don't think that that means that managing inflation expectations isn't important, but I don't think that managing it as a policy lever to try to shift people's consumption is that feasible. I think you do need to manage inflation expectations so that they don't become totally unanchored. But I think that the way to do that is not as much through communication as the Fed would hope, but it's more through actions rather than words. So the big rise in inflation expectations is because of the big rise in inflation.
Beckworth: Now, Carola, you have your own paper on this, which is interesting. You have a paper on the Korean war and inflation expectations. So tell us why this is kind of a neat period to look at this question.
The Korean War and Inflation Expectations
Binder: Sure. And this is one of my favorite papers because I wrote it with a really good friend of mine, Gillian Brunet. We were classmates in grad school and we actually started talking about the idea then, and it took us a couple years to actually get our act together and get the paper done, but it was really a lot of fun. And Gillian is an economic historian and she had done some work with Survey of Consumer Finance data from the 1940s, early 1950s to study the post World War II era. And she noticed that some of these early Survey of Consumer Finance data sets include inflation expectations questions, which is really cool because the Survey of Consumer Finances ask tons of information about the household's finances, their spending, and their spending plans. So we thought, okay, we can do one of these studies that we're seeing so many of about inflation expectations and consumption.
Binder: And the really other nice thing about it is that while 1951 was not a zero lower bound episode, it's like one in some respects because the Survey of Consumer Finances in 1951 was conducted in January and February, which is before the Fed Treasury Accord, which was in March. The Fed Treasury Accord is when the Fed gained some independence from the Treasury so that it could set interest rates and not just keep them pegged to help the Treasury with its wartime financing. But before that, the Fed was not moving around nominal interest rates as a policy tool. It was holding them fixed. So it's sort of like the zero lower bound in the sense that if you get a movement in inflation expectations, that translates one for one to a movement in the real interest rate, because the nominal interest rate is held fixed.
Binder: So we thought it was really valuable to have another zero lower bound-like episode to study because a lot of other papers have focused on the Great Recession zero lower bound episode, which it may lead to some conclusions that are not totally externally valid because there were so many other things going on in the Great Recession. So we were excited to see that this survey data was available and Gillian did a ton of work in getting the survey into usable form. And I would say we found basically what I told you about the other literature which is somewhat mixed or unclear results. I mean, we did find statistically significant results that were in the direction theory would predict meaning consumers who expected higher inflation have consumed a little more recently and expect to consume a little less in the future. But again, it was pretty small. We didn't find it across every category of goods. And so again-
I think you do need to manage inflation expectations so that they don't become totally unanchored. But I think that the way to do that is not as much through communication as the Fed would hope, but it's more through actions rather than words. So the big rise in inflation expectations is because of the big rise in inflation.
Beckworth: Small effect size then.
Binder: Yeah. I think it was pretty consistent with the other literature in that respect.
Beckworth: Okay. It was still a very interesting period to look at because the Fed was pegging rates. So it should be the case that this theory can be tested using that period. All right. So we've been talking about consumer surveys and consumer expectations. Let's go to another way to look at inflation expectations, stepping aside from the household and that's what the markets think. Markets also care about this as well. And of course I'm thinking of TIPS, Treasury inflation protected securities. I look at them often. I invoked them often, but I know they're also plagued with liquidity problems. And the past two years, the Fed was buying up a lot of them. What are your thoughts on TIPS?
TIPS and Other Forms of Inflation Expectation Measures
Binder: I know there's a lot of researchers who have thought a lot about and done a lot of work to try to compute breakeven inflation rates from TIPS that sort of strip away some of those liquidity premia, and other issues like that. So I think they do give us a good, or at least the best we can do, gauge of what the markets are thinking about inflation expectations. I think over the very long run, all sorts of different measures of inflation expectations are correlated. So TIPS measures, surveys of professional forecasters, surveys of consumers. They all sort, of over very long periods, are going to move with inflation itself. But over shorter periods, they can look very different. Especially the consumer measures would differ a lot from TIPS in the short run. So I think it's worthwhile for central banks and for economists to be sort of monitoring all these measures, but not putting too much weight on any one reading or any one measure.
Beckworth: Well, that leads me to the next, I guess, source or form of inflation expectations. That's some kind of combined measure. So I know the Cleveland Fed, they have had this inflation expectations series they've had on for years. And I believe they take information from surveys and from market prices. And I know the Philadelphia Fed also has a term structure of inflation expectations that's based off of survey data and market data. I mean, do you ever use that in your analysis or what are your thoughts on the quality of that type of data?
Binder: Personally, I don't use it that much. Not because I don't like the data, but it's just not part of my common research projects. I think the nice thing about the term structure one is that when often surveys of professional forecasters or of consumers ask about a couple of different horizons, so they might ask the professional forecasters about one year from now, two years from now, and maybe five years, 10 years, but in a lot of different applications, you might be interested in knowing the term structure of real interest rates. And for that you need the term structure of nominal interest rates as well as inflation expectations at every different possible horizon. So I think what they've done that's really useful is come up with estimates of that. So what's the expectation of inflation 23 months from now, 24 months from now 25 months from now. So I think that's the main kind of added value of that.
Beckworth: Okay. I've used it and when I used to blog more regularly, I would throw it up, you know, it’s nice. But the one thing I had in my mind, whenever I put it up is, I really don't know what's going on kind of underneath the hood, how they weight these different pieces. So that's the one thing you're kind of going on. Just you trust the work they've done. So the Fed also has its own measure that's a composite measure. It's the Index of Common Inflation Expectations. I know Ricardo Reis is not a big fan. He's criticized it. So you have to know what's going into these things when you use them. You mentioned one area that we left off and that’s professional forecasters. Any thoughts on those surveys?
Binder: Yeah. For the US, it's the Federal Reserve Bank of Philadelphia that runs the survey of professional forecasters. And I've worked with that survey data as well as the ECBs survey of professional forecasters. The nice things about those are they include those density forecasts or probability forecasts, like the way the New York Fed survey of consumer expectations does. So you can study uncertainty. They ask about a lot of different variables and a lot of different time horizons. It takes a little bit of getting used to, to work with the survey data because you have to keep track of the different horizons. There's some fixed event forecasts and some fixed horizon forecasts. So sometimes they're asking about, “what do you expect to happen in the next year from now,” and sometimes it's like, "what do you expect to happen at the end of this particular calendar year?" So it just takes a little bit of like-
I think over the very long run, all sorts of different measures of inflation expectations are correlated. So TIPS measures, surveys of professional forecasters, surveys of consumers. They all sort, of over very long periods, are going to move with inflation itself. But over shorter periods, they can look very different...So I think it's worthwhile for central banks and for economists to be sort of monitoring all these measures, but not putting too much weight on any one reading or any one measure.
Beckworth: It's so tricky.
Binder: Yeah. It's a little bit technically difficult to work with, but yeah, it's also a useful data set. One thing that a couple years ago, I was looking out with the Philadelphia Fed's survey is they asked the forecasters whether or not they use the natural rate of unemployment to make their forecasts. And so I have a paper where I was looking at how that has changed over time and the professional forecasters seem to have been gradually moving away from using a natural rate of unemployment concept to help make their forecasts. And that was happening as inflation was not really changing, even as unemployment was falling lower and lower than what people originally thought was a natural rate of unemployment in the late 20 teens basically.
Beckworth: Did they give the alternatives they're using or did they just say they're not using the-
Binder: There were a couple of one time survey questions where they would say, “how do you make your forecasts?” And people gave a big mix. So some would use univariate statistical models, multivariate statistical models. Some would use structural models, some would use judgment. It was a pretty big mix. There wasn't any clear favorite, but yeah, I ought to look again at, lately, whether people say they're using U-star to forecast-
Beckworth: So that's interesting. So what the finding is is that Phillips Curve thinking was diminishing in terms of understanding inflation, but then there's got to be some other theory if you're not using that. And maybe it's atheoretical, maybe they're just using statistical models, but there's got to be some alternative theory. It'd be interesting to know what they're thinking. And then today, what's going on in those surveys today. Well, let me ask you a question about inflation expectations. Because sometimes you hear people say, "These surveys aren't any good. They don't actually forecast well, actual inflation."
Beckworth: And I had a reply that I would often use and I think it's more applicable to maybe pre-pandemic. I want to hear your thoughts on this. So Milton Friedman calls this the thermostat analogy, but the basic idea is if the Fed is aiming to stabilize inflation and that includes forecasts of inflation, whenever there's a potential shock that could throw inflation off, the Fed's going to come in and step in and respond to that. So some shock happens, maybe oil prices go up, there's a war somewhere, some temporary deviation from target and say the markets, households, people are forecasting higher inflation, but the Fed steps in and offsets that. And if Fed does that in a systematic manner, then you would expect there to be no correlation. If the Fed's doing its job, I guess, you would expect there be no correlation between a potential forecast and the outcome. Does that make sense?
The Thermostat Analogy of Inflation
Binder: Yeah, it does make sense. I think that the issue with the Fed responding to any of these kind of signals that they're getting from say household inflation expectations is that sometimes household inflation expectations really are reflecting oil prices, gas prices. And the Fed with its aggregate demand policy shouldn't necessarily respond to oil price shocks if it's a supply shock. But if that shows up in kind of an excessive way in household inflation expectations and it responds to that, then it's sort of indirectly responding to supply shocks. And then I can see it adding some volatility even in the markets. If markets know that the Fed is planning to respond to consumer surveys and the consumer surveys are responding to the oil prices, then the markets are going to respond to the oil prices and the consumer surveys. And I think there's going to be some problems in that whole chain of events. But-
Beckworth: But if the Fed's doing its job, if it's systematically responding to shocks that could affect inflation… Now again, your point is, and I agree with you and this kind of is pointing towards nominal GDP targeting, but let's say the Fed sees through supply shocks, but other shocks may affect demand, let's say, and it's systematically responding... In fact, I think there's a lot of like… back in the '90s, early 2000s, a lot of VAR studies that if you look at a federal funds rate shock before say 1980, it had a big effect on inflation, but afterwards it doesn't. And one interpretation is that's because any kind of movement is really a systematic response. So if the Fed's doing its job, would we expect there to be less of a relationship between forecasts of inflation and actual inflation?
Binder: Well, are the forecasts capturing the fact that the Fed is going to do its job?
Beckworth: That's a good question. Yeah.
Binder: It's just like this-
Binder: Circularity, but yeah. I mean, this is the bigger problem in trying to study the effects of monetary policy.
Beckworth: Identification, right?
If markets know that the Fed is planning to respond to consumer surveys and the consumer surveys are responding to the oil prices, then the markets are going to respond to the oil prices and the consumer surveys. And I think there's going to be some problems in that whole chain of events.
Binder: Yeah. The paper that I love to teach in my upper level elective classes is the Romer and Romer monetary policy shock paper, where they show that if you try to measure the response of inflation or industrial production to change it in the federal funds rate, you're not going to find much because the changes in the federal funds rate are responding to what they're anticipating is going to happen. So they make this shock series, a monetary policy shock series where they try to get exogenous movements in the federal funds rate that sort of wipe away any anticipatory effects. So they basically estimate a Taylor rule and they take the residual terms there. And they said these are the changes in the fed funds rate that were not related to the Fed's own forecasts of future economic conditions. So they're sort of these like orthogonalized or kind of pure monetary policy shocks. And then they show that you see more of a response of inflation and output measures to those exogenous shock measures than you would to just change in the federal funds rate.
Beckworth: Yeah. That is the challenge of macroeconomics. How do you identify truly exogenous policy shocks, ones that aren't ... We're simply responding to what's going on in the world around them. Okay. So we've been talking about maybe more positive economics here like this is how we measure inflation. This is whether it's good or not, whether we can use it, but let's move maybe to the normative side, the kind of the prescriptions that flows out of your research. And I know maybe you don't do a lot of that in your work. I know you have advocated normal GDP targeting, but what should the Fed be doing, in your view, what should the Fed be doing today in terms of like ... We're looking at, for example, these inflation forecasts from households. They've gone up. Now breakevens have actually started to come down as we are recording this. Should the Fed be reading into these forecasts of households and be responding to them?
How Should the Fed React?
Binder: Yeah, that's a tricky question. I mean, they are, like they say, data dependent. They need to be reading into all of the different data that they have available to them. But I do think they need to take the inflation expectations measures from consumer surveys with a bit of a grain of salt. One reason I say that is because, well, what you hear the media reporting or what you even hear Powell talking about in speeches and press conferences when he says that inflation expectations have risen, it's usually referring to the median inflation expectation or the mean, but usually the median. And over time, the time series variation that you get in consumer inflation expectations, that variation over time is actually much smaller than the variation you get at any point in time in the cross section. So if you're taking these survey responses seriously enough to respond to them, then why do we believe that the median tells us something, if we don't believe that these tales are telling us anything. If some consumers are reporting in any given month of the survey, you have some consumers reporting 25% inflation expectations.
Binder: That for me is really hard to think about what that means, but why should the Fed care more about a movement in the median from 4% to 5% than they care about this huge variation in the cross section? So, yeah, I think that's a reason to be a little bit skeptical about what the surveys are telling us. Like I mentioned, the correlation of the consumer surveys with gas prices is another reason to be, I think, a little bit cautious in responding too much to them. And also the difference between consumer survey measures and professional measures or market measures is often really related to gas prices. So when you have these big movements in oil and gas prices that the Fed shouldn't necessarily be responding to, I think that's maybe the time to put a little more weight on the TIPS measures and on the professional forecasters’ measures.
If you're taking these survey responses seriously enough to respond to them, then why do we believe that the median tells us something, if we don't believe that these tales are telling us anything. If some consumers are reporting in any given month of the survey, you have some consumers reporting 25% inflation expectations. That for me is really hard to think about what that means, but why should the Fed care more about a movement in the median from 4% to 5% than they care about this huge variation in the cross section? So, yeah, I think that's a reason to be a little bit skeptical about what the surveys are telling us.
Beckworth: Okay. So take it with a grain of salt when you're doing policy. So in closing, I want to settle in on this last area and that is, there's been a lot of discussion about what is driving inflation? Is it supply side shocks, demand shocks, and there's team transitory. I was a part of team transitory. My forecasts were way off. So mea culpa here, I was completely wrong about 2021 and my inflation forecast, but today, I think one can make a more convincing case. There is a lot of inflation driven by demand side pressures. There's also still some supply side pressures. Do these inflation forecasts help us figure out that divide… is there any way policymakers can use these forecasts to get a sense as to whether we should be responding to the inflation we're seeing?
Binder: That's a good question. I think that they can look at what the markets are expecting about not only inflation, but also about oil prices. And I think as they see the fall in gas prices, they can maybe know that some of the supply side pressures are easing up. But I think rather than looking so much at the expectation surveys, it's maybe more important to look at the different components of the price index and use that as kind of better evidence about where the inflation is coming from and how much of it is demand driven. But at this point, I mean, inflation is just way too high. And so at this point it's pretty clear that they need to keep tightening. The bigger question is going to be, once we start seeing more of a slowdown in inflation, once it becomes a little less obvious what they need to do, that's when it's going to get trickier as far as which measures to track. I don't know what's going to happen with consumer expectations when inflation starts falling. How long will it take for the expectations to start falling? And we don't have that many examples of inflation falling from a high point when we also have survey measures to track.
Beckworth: That's a good point.
Binder: We do have the decline in inflation expectations during the Volcker disinflation. But other than that, I don't think we can say enough about what's going to happen to consumer inflation expectations as inflation starts falling and how good of a prediction that will be for future inflation dynamics.
Beckworth: Well, that's interesting. I mean, we were beginning to see gas prices go down just recently. So it'll be interesting to see what happens in these consumer surveys, because you said they do track each other-
Binder: They do track gas prices. So I do think we will see inflation expectations start falling now that gas prices are going down. I think it will be concerning if we don't.
Beckworth: There you go. There's a good test.
Binder: Yeah. So yeah, it is… That's going to be the test, the next couple of months. I mean, I think just out of pure interest, everyone should just watch what's going on with the consumer expectations. But I mean, it would be hard to be at the Fed right now and deciding how to respond to those.
Beckworth: If household consumer inflation expectations start to go down, then we feel okay, things are okay, but if they stay stuck at high elevated levels, even as gas prices go down, then, then maybe inflation expectations are becoming unmoored, unanchored.
Binder: It could be. Even that is hard to know for sure, because there's also a lot of politics in these inflation expectations-
I think rather than looking so much at the expectation surveys, it's maybe more important to look at the different components of the price index and use that as...better evidence about where the inflation is coming from and how much of it is demand driven. But at this point...inflation is just way too high. And so...it's pretty clear that they need to keep tightening.
Beckworth: That's true, yeah.
Binder: ... surveys. So I think a lot of people, as long as they don't like what the president's doing, they're going to still say high numbers. So there's actually a huge political divide. When the political party that they like is in power, they report lower inflation expectations. When the party that they don't like is in power, they report higher inflation expectations. So as long as the president's approval ratings are low, we might just see high inflation expectations. And again, should the Fed respond to that? Probably not, but it's just so hard to know. And I think that politicization of inflation and of inflation expectations has increased a lot over the last couple years as well.
Beckworth: Okay. Well, if that our time is up. Our guest today has been Carola Binder. Carola, thank you so much for coming on the show.
Binder: Thanks for having me.
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