South-Western College Publishing - Economics  
Double Talk: Long-term Trend or Short-term Jolt?
Subject Inflationary Expectations
Topic Employment, Unemployment, and Inflation
Key Words

Inflation, Interest Rates and Federal Reserve Policy

News Story

Inflation feeds in part on itself, so part of the job of returning to a more stable and productive economy must be to break the grip of inflationary expectation." Volker was Fed Chairman from 1979 to 1987. He finally defeated the inflation dragon, but not until the U.S. economy had been given some of the harshest economic medicine that Americans have ever seen: interest rates approaching 20 percent.

Now, current Chairman Greenspan and his Fed colleagues have to wrestle with inflationary expectations as they contemplate raising interest rates from the lowest levels in decades. On the one hand, they are saying that inflationary pressures are "not likely to be a serious concern." On the other hand, they are going out of their way to suggest that their economic analysis may be wrong, and if it is, the Fed will relinquish their plans to raise rates at a "measured pace" and move more aggressively to head off potential inflation and cool down the economy.

Sounds like double talk: Which is it? Does the Fed believe that inflation does not pose a threat? Or is the Fed suggesting that inflation may be a problem after all? The answer may lie in the distinction between inflation itself and the inflationary expectations that Volker rightly identified as a potential source of inflation.

The Fed seems to see the recent jumps in energy, clothing and food prices as temporary jolts rather than as part of a longer-term trend. They contend that labor costs are rising slowly because the number of unemployed workers remains high. In addition, even if new job creation increases labor costs, the Fed argues that firms can absorb the higher costs, because companies' profit margins have been unusually comfortable.

Fed officials recognize that inflation expectations can themselves contribute to inflation. If consumers expect prices to increase rapidly over the next year, they will likely buy now to avoid higher expected prices in the future. These expectations become self-fulfilling prophecies. The rush to buy now can itself push prices higher. " A rise in inflation expectations tends to become self-fulfilling as people seek to protect themselves in the process of setting wages and prices," said Donald L. Kohn, a Fed governor, in a speech in June, 2004.

"What's at issue here is whether or not the Fed is right," Said Lyle E. Gramley, a former Fed governor and now a senior adviser to Schwab Soundview Capital Markets. "One can make a case that inflationary pressures are not a concern, but it's awfully hard to make a compelling case."

Since people have not developed inflationary expectations because they are confident that the Federal Reserve will protect a stable and productive economy by fighting inflation, the Fed may have to move at more than a "measured pace" to maintain such hard-won confidence by the public.

(Updated August, 2004)

Questions
1.

Why do large numbers of unemployed workers keep wage costs low?

2. Explain the notion of inflationary expectations and how these expectations become self-fulfilling prophecies. Give an example from you own life of how such expectations might contribute to inflation.
3. Ask your parents or read articles about what the economy was like during Volcker's reign as Fed Chairman, when interest rates approached 20 percent. How did such high inflation affect people's lives?
Source Edmund Andrews, "A Fight Against Fears as Well as Inflation", The New York Times Online, June 20, 2004.

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