Mar

25

It's hard not to be impressed by Fed Gov. Fred Mishkin's Friday night speech. He comes across as a humble, clear, knowledgeable technocrat with a sense of history, and a command of arcane monetary matters. But reading his text in the context of where we are on the timeline of monetary mysticism is a chilling experience.

First, in keeping with this cycle's fashion, he put the public's inflation expectations front and center as an analytic deus ex machina:

"What is particularly attractive about highlighting a better anchoring of inflation expectations as probably the primary factor driving the changes in inflation dynamics is that this one explanation covers so many of the stylized facts–an application of Occam's razor. Indeed, I have always become more confident in a theory if it can explain a number of very different facts. This is why I am so attracted to the view that inflation expectations are a key driving factor in the inflation process…"

Then, he reintroduces the comic book analysis of commodity forward prices:

"…from the mid-1980s through the first years of this decade, energy price movements were smaller and more transitory. We see this in futures markets, in which oil prices in far-dated futures contracts moved much less than spot prices over this period, suggesting that people expected a quick reversal in any rise in oil prices. Such transitory shocks to energy price would presumably have a smaller effect on inflation than the more-persistent oil price shocks of the 1970s and early 1980s…."

Since we can dismiss the notion that Dr. Mishkin is unaware of the no arbitrage rule, we are left to puzzle over what seems like a willful misreading of these tealeaves. There's a reaffirmation of rhetorical oneness with the ECB:

"…we remain vigilant about developments in the economy that could lead to persistent departures of inflation from levels that are consistent with price stability…"

And here is some Winston Smith material.

"Although solidly anchored inflation expectations are indeed highly desirable, they could pose a bit of a problem for monetary policy if they were at a level somewhat above or below the rate preferred by policymakers. Under such circumstances, the central bank would likely be interested in shifting the public's expectations in a more favorable direction. Whether such adjustment would be easy or difficult is, unfortunately, quite uncertain because we do not understand the expectations-formation process very well…"

So, the Fed likes well-anchored public inflation expectations. Really. But they have to be the right expectations, Goldilocks expectations, not "above or below the rate preferred" by the Fed. You see, the public, well, they just might not know what inflation is:

"…long-term inflation expectations from the Reuters/Michigan survey have been running much higher for a number of years, at around 3 percent. However, this figure seems overstated in light of the persistent bias found in the short-term inflation expectations reported by this survey. Correcting for the bias, these survey results are probably more in line with PCE inflation closer to 2 percent.

"…expectations from the companion one-year-ahead expectations have come in about 75 basis points higher than actual PCE inflation since 1990, suggesting that there may be a systematic bias in the responses to the Reuters/Michigan survey…"

Who'd have guessed the public would intuitively grok positive yield curves, risk premia, and the potential for perfidy on Constitution Ave.? Not the Fed! The public's rational expectation for the annual decline in their currency's purchasing power is defined away as a "systematic bias" subject to "correcting."

Naturally, this calls to mind the scene from 1984 where the thought policeman O'Brien holds four fingers up before Winston Smith, demanding that Smith say there are five fingers aloft. That didn't turn out too well for Smith.

Back to our monetary dystopia, Mishkin clearly signals the markets that he expects core-core inflation to fade toward 2% once the energy price spike finishes working its way through the economy:

"I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent. This process may take a while in light of the recent rebound in prices for gasoline and other petroleum products. These price increases have boosted the cost of producing many non-energy goods and services, and as firms gradually pass on these higher costs to their customers, monthly readings on the change in core prices are likely to be higher than they otherwise would be. Once this process is completed, however, we might expect consumer price inflation to move into better alignment with long-run expectations and thus settle in around 2 percent…."

Finally, we learn that the FOMC's iteration of Minitru is very sensitive to where public perceptions rest relative to the Fed's favorite measures, and perhaps more subtly, just how much inertia the Fed sees in those perceptions:

"Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment–which I should stress is subject to considerable uncertainty–flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about…"

Yes, the suits on Constitution Avenue run a cost/benefit analysis on the efficacy of manipulating the public's understanding of its own money.

It's not Orwell, but Nora Ephron who best sums it up: "No matter how cynical I get, I just can't keep up."

 


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