The Cleveland Fed Reports Inflation Expectations Are Dropping Fast; Bernanke Doesn’t Seem to Care

Coinciding with the latest report on the consumer price index, showing the largest one month drop in the CPI since 2008, the Cleveland Fed issued its monthly update on inflation expectations.

News Release: June 14, 2012

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.19 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

As the attached chart shows, the current expected rate of inflation over a 10-year time horizon is at an all-time low, dropping 30 basis points in the last two months. But in his testimony to Congress this week, Chairman Bernanke did not seem to think there was any problem with monetary policy. It’s all those other guys’ fault.  Well, who exactly is responsible for falling inflation expectations, Mr. Bernanke, if not the FOMC? Does a sharp drop in inflation expectations, the sharpest since the horrific summer of 2008 give you any cause for concern? If so, is there any change in policy that the FOMC plans to undertake at its next meeting? Or is the FOMC only concerned about inflation expectations when they show signs of becoming unanchored on the upside, not the downside?

UPDATE (3:44 PM EDST):  A quick look at the excel file showing the Cleveland Fed’s estimates of inflation expectations at maturities from 1 to 30 years shows that one-year expectation fell last month to 0.6% from 1.4% the previous month.  That is the lowest one-year inflation expectation since March of 2009 (-.0.3%) when the S&P 500 fell to 676, 10% below the previous trough of 752, in November 2008.  We are treading on very thin ice, and the only thing that may be keeping us afloat is the market’s expectation that the FOMC has no alternative but to adopt another round of Quantitative Easing.  Let’s see if the confidence of the market is justified.


21 Responses to “The Cleveland Fed Reports Inflation Expectations Are Dropping Fast; Bernanke Doesn’t Seem to Care”

  1. 2 Lars Christensen June 15, 2012 at 11:27 am

    David, this is simply horrific numbers. The euro crisis has caused Bernanke to fall way behind the curve – once again. This in my view clearly shows the problem of not having a clearly defined monetary rule.

    If the Fed won’t go for the real thing the FOMC should at least announce that it would not allow inflation expectations to drop below 2%. That at least would ensure the US economy against new velocity shocks…

    Damn, central banks around the world have failed so utterly…


  2. 3 Christiaan June 16, 2012 at 3:31 am

    So the Fed already broke its employment mandate. Now they’re breaking the price stability mandate (as they themselves formulate it, they’ve time and again confirmed the 2% is not a ceiling). So why isn’t this a highly incompetent Fed? All I can say is that he’s doing better than Draghi, which is really not saying anything.


  3. 4 Benjamin Cole June 16, 2012 at 6:32 am

    Can not we ever declare victory in the war against inflation? Or the war against economic growth?

    Do we have to do a Bank of Japan?


  4. 5 W. Peden June 16, 2012 at 6:40 am

    A good but disturbing observation. Most disturbing is thinking that, if these inflation expectations don’t provoke a change, then basically things have to look catastrophic for the FOMC to do anything. Even in mid-2010, there was less justification for action than now, and the FOMC had the good sense to act then.

    Perhaps the historical American parallel is not so much with the 1930s, but the 1960s, 1970s and early 1980s, when policymakers repeatedly only acted to stave-off inflation when things were awful and even then only temporarily. Given that pattern existed in your history for about 15 years (the 1967 squeeze until the post-1982 moderation) and the had “stop-go” and “go-stop” policies from about 1919 to 1993 (with the notable exception of 1931-1945) we could be in for a long-period of bad macroeconomics policy.

    I don’t want to be alarmist, but that 1919 to 1993 period doesn’t just happen to coincide with the UK’s decline as a world power, ending with the final humiliation of Black Wednesday in September 1992. There’s no reason to think that the US may not undergo a similar decline, if monetary policy isn’t fixed. It could be argued that you’re already well down that road and the pseudo-solutions offered by left and right are not encouraging.

    It’s tactical thinking, as opposed to strategic thinking, and one of the better arguments for abolishing central banks is that monetary policy is too important to depend on the appointment of a set of strategic thinkers.


  5. 6 dwb June 16, 2012 at 11:15 am

    we have a monetary policy rule:
    1. wait until the apocalypse is nigh
    2. pro claim monetary policy is highly accommodative
    3. wait and do nothing
    4. by 2,000,000,000,000 treasuries when the crisis is in the rear view mirror


  6. 7 Andy Harless June 16, 2012 at 1:21 pm

    The Cleveland Fed’s estimate seems implausible to me. The 10-year TIPS breakeven is 2.16% (assuming I’m reading the quotes and doing the calculation correctly). This implies an inflation risk premium of at least 97 basis points (probably significantly more because there is also a liquidity premium that should raise the yield on TIPS relative to nominals). That just doesn’t seem at all reasonable, unless people think there’s a really big tail risk, that the Fed will change its mind about its 2% target and go for something like 4%, or maybe decide to implement the target as a retroactive NGDP level path target so that it can allow a lot of temporary inflation while sticking to its longer-range goal. The latter isn’t entirely out of the realm of possibility, but is it a big enough risk to justify a full percentage point risk premium? If that’s the case, the situation is even worse than you put it, because that possibility is pulling up the average, so, conditional on the absence of such a dramatic change, the expected inflation rate is even lower. But I just don’t find that view plausible. I think the Cleveland Fed is misreading the indicators.


  7. 8 Julian Janssen June 16, 2012 at 8:02 pm

    Well, one question I’d like to see answered by the market in the coming months is whether the declining inflation expectations are going to actually cause a contraction similar to what would be expected from a raise in the interest rate, as your model would presumably indicate or whether there is actually going tone some sort of apparently spontaneous recovery. Not that I buy that idea, butit would be an interesting result…


  8. 9 JP Koning June 17, 2012 at 6:50 am

    Here’s another interesting chart:

    Texas oil production is at 20 year highs.

    The Cleveland Fed indicator is based on zero-coupon inflation swaps, and these in turn are priced off of expected headline inflation (as are TIPS). Headline inflation is highly volatile, most of this volatility due to gasoline prices.

    The collapse in TIPS rates and inflation swap rates may be due to something very healthy; a fall in oil + gasoline prices due to a renewal in US oil production and a rebirth of the once-decaying US onshore oil industry. In other words, there may be a very real component to the decline in inflation expectations, and less of a monetary component.


  9. 10 dwb June 18, 2012 at 8:56 am

    sorry to be so glib about my comment above “we have a monetary policy rule”

    my point was that we need a good rule, not just any rule. A rule that responds for example to the CPI when import prices are rising is a bad rule. I’d rather have no rule than a bad rule.


  10. 11 Tas von Gleichen June 19, 2012 at 10:04 am

    1982 must have been a bad time to be around. Even though 7 percent is still easily manageable. Considering that hyperinflation occurs at 50 percent.


  11. 12 David Glasner June 19, 2012 at 11:48 am

    Marcus, Indeed!

    Lars, Especially if the rule implies the correct policy.

    Christiaan, If you are expecting me to defend the Fed, I’m afraid that you will be disappointed. But if the standard of performance is the ECB, I guess one could say in the Fed’s behalf that they could have done worse. That would be really faint praise.

    Benjamin, Some wars never end.

    W. Peden, You are taking the discussion of monetary policy to a whole new level. I’m not sure what the significance is of the 1919 to 1993 bookends of the period that you singling out for special attention or why you think 1931-45 is an exception, so I am not really in sync with your thought process. On the other hand, I do find the analogy that you draw between excessive focus on full employment in the late 1960s and 1970s and excessive focus on inflation in the period since 2008 a very interesting idea.

    dwb, Thanks for explaining that to us.

    Andy, I don’t understand how the Cleveland Fed makes those estimates. However, if you look at their graphs and tables you will see that their estimates of short-term real interest rates have shot up in the last two months. So you can’t just look at the breakeven TIPS spread and infer that that that spread is broken down between inflation expectations and the inflation risk premium. In their estimates the risk premium is fairly flat, and they are estimating that real rates are rising (because of liquidity effects, I assume) while inflation expectations are falling.

    Julian, Yes, it will be interesting. But the chances for a recovery getting under way without a bid dose of monetary stimulus do seem to have evaporated since the early spring, when hopes were rising.

    JP, Thanks for the link. I don’t think that a recovery in US oil production is driving oil prices down. However, the recognition that there is a developing technology that will allow greatly enhanced production in the US and in many other places is certainly shifting market expectations of future prices down, which makes holding inventories a lot less attractive than it was until recently. That said, I agree that the recent drop in inflation expectations has been influenced by the changing dynamics of world oil markets, not only monetary policy. Insofar as falling inflation expectations are driven by a positive oil supply shock, that reduction is benign.

    dwb, Right, see my response to Lars above.

    Tas, I remember 1982. It was scary, but not nearly as bad as 2008.


  12. 13 cantillonblog June 22, 2012 at 9:23 am

    JP Koning is spot on about the influence of shale oil (and indirectly shale gas) on crude prices, and I wrote in March that we should expect this to happen (lower crude prices, dragging down breakevens, especially short term breakevens).

    David – market monetarists cannot have it both ways without losing any pretence at intellectual coherence.

    They cannot on the one hand say that the collapse in TIPS breakeven spread post July 2008 reflected imminent and realistic fears of a depression and that the move in prices reflected real expectations rather than an increased risk premium due to temporary supply/demand imbalance; and on the other depend on a model (the one that underlies the Fed paper) that suggests this move in breakevens was a mere cheapening of an illiquid product under a distressed scenario where liquidations abounded.

    If you believe the Cleveland Fed paper, you must admit that the situation post July 2008 was not nearly as bad as one would expect solely based on the move in breakevens. On the other hand if you emphasize the breakeven move, you must think there is something wrong with the Fed approach.

    Furthermore, since deflation is only really a risk to the extent it impinges on either nominal wage growth or nominal asset pricing, shouldn’t you rather focus on direct measures of such? My sense has been that peoples expectations about wage growth in the US have stabilized and are starting to improve. Similarly stocks are not too far from their highs.

    So on what basis is it that you argue we ought imminently to fear the arrival of bad deflation?


  13. 14 David Glasner June 28, 2012 at 9:23 am

    cantillonblog, You make a fair point. One ought to distinguish between falling expectations that are associated with a positive supply shock. The problem we have is that it is hard to disentangle the causes of the recent drop in crude oil prices. It seems to me to reflect expectations of a falling demand for oil because of expectations of a weakening economy and expectations of an increasing supply of oil and natural gas, because of recent discoveries of new sources of oil and gas and the rapid development of new extraction technologies. I also agree that the breakeven TIPS spread cannot always be interpreted in a straightforward fashion, particularly when there are sharp breaks indicating that markets may not be functioning or that the option value of the TIPS is starting to dominate its pricing. But, even given those qualifications, tracking the TIPS spread provides a good indication of the direction in which inflation expectations are moving. My view is that inflation is already too low and therefore further downward movements in inflation expectations are more likely to portend a deterioration than an improvement in economic conditions. But I accept your point that a sufficiently large positive supply shock could alter the otherwise likely effect of falling inflation.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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