The Fed’s Most Powerful Tool Is Your Belief

And after five years above target, the hawks worry it’s wearing thin.

Before we start, a quick announcement: Platypus Economics wants to hear about how the economy is affecting you this election season. Tell us about it in a short video and we might play it on a special episode of the show!

Submit your response here: platypuseconomics.com/questions

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Last week, the Federal Reserve met and made the decision not to raise interest rates. This is likely a case of kicking the can down the road: markets now predict a rate hike in December.

I wrote about this when it happened, and you can catch up here:

The Fed Knows It Needs to Hike. So Why Wait?

Now it’s time for The Professor Is In, where my producer, Augusta Chapman, brings me audience questions. Think of it like office hours: my door’s open — come on in.

Inflation expectations help cause inflation realities

Augusta brought me an audience question about the Fed and inflation. A commenter said that they had been reading quotes where people said our current inflation is more structural than cyclical. Augusta asked if those things could really be separated out, and if so, what could the Fed do about it?

I don’t usually associate the word “structural” with inflation — it’s mostly used to describe unemployment. But I think I understand the question.

Is inflation that’s caused by temporary events actually temporary? Oil prices change because of geopolitical events, or tariffs get put on and then get struck down. When those things fall off the front page of the newspaper, will the inflation go away? Or does it become more deeply rooted?

The way modern economists think about that “deeper rooted” thing is by way of inflation expectations. The word they use is “anchored.”

Do people expect higher inflation in the future? If so, they may demand wage rises to pay for more expensive things. If they do that, then their bosses’ costs go up. And that actually creates higher inflation.

This is what the Fed is for

The Fed’s inflation target is 2%. That’s the amount it is aiming for every year. The whole idea with having a Fed that has an inflation target is that I can say to Augusta, “What do you think inflation is going to be next year?”, and she doesn’t have to do all the calculations.

She could think to herself, “How’s the economy? What are other people thinking?” But she knows that the folks in charge are doing whatever it takes to get to 2% inflation. So she says, “I think it’ll be 2%,” and inflation expectations stay anchored.

Whatever else happens in the economy, anchored expectations mean that we all think there will be 2% inflation, and that tends to create 2% inflation.

30 years of certainty

Augusta and I have lived very different lives when it comes to inflation. When I was in my teens, I bought a bond that had an interest rate of 15.5%. That was partially because interest rates were high, but the deeper cause was high inflation. This was in Australia in the 80s, where inflation was sometimes incredibly high and sometimes incredibly low (America experienced the same thing, but mostly in the 60s and 70s).

Augusta’s had inflation of around 2% her entire life. What a charmed existence she’s had! (Let’s just set aside the financial crisis and COVID pandemic and AI revolution for now. As Augusta said, every generation has a thing.)

My guess is that the original question here came from someone who’s lived through an era when inflation got unmoored. When it does, it can become self-perpetuating, and in many countries, that’s currently the case. This just hasn’t happened recently in the U.S. Though many folks — including folks at the Fed — worry that could happen after five or six successive years of inflation above the Fed’s 2% target.

A trade-off, not a menu

Augusta also asked what central bankers were thinking about in the 50s and 60s, before inflation targeting became the standard mode of operation.

I’ll answer the question, but first, a detour to the Outback Steakhouse. Picture yourself running your own franchise. You have 100 seats, and you have to print next year’s menus. In a hot economy, 120 people turn up wanting a Bloomin’ Onion. In the long run, you’d expand the restaurant to meet demand, but in the short run, your capacity is fixed. With more customers than seats, you might as well raise your prices.

If what’s true of the Outback is true of America, you’ve just discovered the Phillips curve. When unemployment is low and demand is hot, inflation tends to be higher. When unemployment is high, inflation tends to fall.

Central banks in the 50s believed that trade-off was a menu. You could sit down and ask yourself, what do I feel like this year? A little more inflation? A little less unemployment?

The problem is expectations. Order the low unemployment, and people start expecting higher inflation. That expectation creates more inflation on top of the queue out front. You thought that you were ordering moderate inflation, and you ended up with very high inflation instead. The Phillips curve is a statistical regularity that stays regular until you treat it like a menu.

Structural vs cyclical

So will today’s inflation become “deeply rooted”? Let me go more in-depth on the theory here.

Inflation depends on expectations. Expectations depend on policy. Policy depends on ideas about policy, and when I talk to economists in the field, their ideas haven’t changed much in recent years. They still think it’s a good idea to have an inflation target to keep things anchored, and since that theory won out, nearly every peer country that adopted a serious inflation target has had persistently low inflation (with asterisks for things like the pandemic).

So I don’t think the underlying ideas are changing, which means I don’t think policy is changing. I expect the era of slow and low inflation to stick with us.

But I’ll also give the “raise rates now” camp at the Fed their due. Their argument is that the Fed hasn’t actually been anywhere near its target for half a dozen years. If that continues, eventually, people will stop believing it. That’s the idea that inflation expectations may become unanchored, and you might no longer reflexively expect that next year’s inflation will be 2%. That’s the version of “deeply rooted” worth worrying about.

More on the Fed decision

Other questions Augusta put to me:

• What’s the strongest case for waiting to see whether September’s rate hike is working?

• What did Milton Friedman mean when he said monetary policy operates with “long and variable lags”?

• What other strange ideas have central banks fallen for?

Finally, why does the Fed move in quarter-point steps?

A quarter point is smaller than it feels. Honestly, how different was your life last week because the Fed didn’t raise rates?

I think the quarter-point step is mostly about humility. If you believed that you had a finely tuned knob you could constantly twist to change things around, you might develop a bit of a God complex. The truthful answer is nobody knows exactly where rates should be, so you take a guess and move a step closer.

Watch the full episode for the rest.