economic brief

OctOber 2008, eb08-01

Over the past year, rising inflation paired with growing unemployment inflation expectations: have posed an increasingly complex problem for the Federal Reserve. their sources and effects The Consumer Price Index (CPI) jumped 5.6 percent from July 2007 to July 2008, a rate of growth not seen since the early 1990s. Given this macroeconomic climate, understanding the Federal Reserve’s ability to by Yash P. Mehra and devin reilly control inflation has become even more important. A recent paper by Sylvain Leduc, Keith Sill, andTom Stark (2007), referred to hereafter as LSS (2007) 1 , analyzes the significance of the public’s inflation expec - Shocks to the macroeconomy tations on actual inflation.The authors find that, prior to 1979, the Fed accommodated high inflation expectations, which in turn created can affect the public’s expectations persistent inflation spikes.This behavior is not present after 1979, about inflation. But if the providing evidence that the Fed changed its response to inflation. Federal Reserve monitors those While LSS (2007) focused more on movements in actual inflation, a recent paper from the Richmond Fed investigates macroeconomic expectations carefully and determinants of inflation and their effects on expected inflation. 2 vigilantly pursues price stability, In their spring 2008 article in the Federal Reserve Bank of Richmond’s Economic Quarterly “ On the Sources of Movements in Inflation Expec - it can establish credibility and tations: A Few Insights from aVAR Model,” Yash Mehra and Christo - keep inflation in check. pher Herrington use a model similar to LSS (2007) to measure the impact of macroeconomic shocks on expectations and how these effects have changed over the sample period: 1953 to 2007.

Current research on this topic is of considerable interest to the Federal Reserve, as its principal task is achieving and maintaining price stability.This Economic Brief provides a discussion of the methodology and results of Mehra and Herrington’s paper, as well as its implications for Federal Reserve policy in regards to inflation.

MOdel Mechanics and Variable MeasureMent Mehra and Herrington’s paper uses a structural vector autoregression (VAR) that was initially used in LSS (2007). AVAR is an econometric model that describes the evolution of the interactions between several variables. In this context, the authors use aVAR to analyze the behavior of expected inflation, actual inflation, commodity prices, the unemployment rate, the short-term nominal interest rate, and an oil shock variable. Using a structure similar to LSS (2007), the authors are able to specify the model so that only certain variables are affected by contemporaneous information. For instance, under the basic setup, expectations of inflation in a given time period are unaffected by the eb08-01 - the federal reserVe bank Of richMOnd other variables in theVAR at that time.They are affected only by past levels of expectations and past values of the other five variables. Moderation (GM) period, the first half of 1985 through the first half Mehra and Herrington also use alternative specifications, where of 2007. 5 During the GI period, we see that both actual inflation and expectations can respond contemporaneously to all other variables. expectations shocks have a sustained impact on expected inflation, This exercise does not significantly change the results of the model. lasting all 12 years of the simulation. In the GM period, these same shocks cause only transitory increases in expected inflation: Expecta - Expected inflation is measured by the Livingston Survey, which sum - tions begin to fall after only one year, quickly returning to pre-shock marizes the eight-month-ahead CPI forecasts of experts from industry, levels. government, academia, and banking, and is conducted twice a year by the Federal Reserve Bank of Philadelphia. Actual inflation is taken as For a 100 percent commodity price shock, expectations in the GI a six-month change in the CPI. Commodity prices and unemployment period see a 10 percent increase after a year, lasting throughout the are six-month averages of their respective indices. Short-term nominal entire simulation.Yet, for the GM period, we see a very small jump in interest rates are six-month averages of the three-monthTreasury bill expectations one period after the same shock. Also, after one year, rate.The oil shock is measured by a dummy variable, which can be expectations fall back to pre-shock levels. Unemployment increases formulated in one of two ways, both outlined by James Hamilton have opposite effects in the GI and GM periods. In the former, (2003). 3 The first method looks at oil price increases stemming from expected inflation permanently increases, while in the latter, there is drops in oil production caused by political events. Hamilton isolates a temporary decrease in expected inflation.These results point to a five of these events, and the dummy variable takes a value equal to change in the nature of expectations between the GI and GM periods the drop in world production for each event and is otherwise zero. – namely, they suggest a stabilization in expectations in the 1980s. The other method measures net oil price increases relative to past two-year peaks.This allows theVAR to consider recent episodes in MOnetarY POlicY resPOnse tO VariOus shOcks which oil shocks were not caused by political disruption, but rather A common explanation for persistent inflation in the 1970s is that the by growing demand from developing economies. monetary policy response was not sufficiently aggressive. Figure 3 shows the responses of actual inflation, expectations, the nominal exPectatiOn dYnaMics change in the 1980s interest rate, and the real interest rate to a 1 percent expectations Figure 1 contains a graphical representation of some of the variables shock.This figure is broken into three periods: GI, GM, and a third included in theVAR.They are split into two separate time periods, the period, 1979 to 2001. In the pre-1979 sample, the nominal rate rises first half of 1950 through the first half of 1979, and the second half of with a shock, but not enough to keep the real rate positive for an 1979 through the first half of 2007.We notice from the top panels of extended period of time. For the 1979 to 2001 period, the response is Figure 1 that expectations do move with actual inflation in both peri - far less accommodating to inflation, with a more than 1 percent jump ods, but also tend to under-predict inflation when it is in the real interest rate. For the GM period, the response is somewhat accelerating and over-predict it when it is decelerating.This implies muted; however, Mehra and Herrington argue that this may be that survey participants did not respond immediately to actual infla - because this period witnessed low and stable inflation, which would tion numbers, which in turn suggests that the co-movement of the two naturally lead to less aggressive responses than when the Fed was at - variables may have come from actual inflation responding to expecta - tempting to reduce inflation during the 1980s.There are similar inter - tions.We can also see from the movements in the real interest rate that est rate responses to a shock in commodity prices.The real rate the Fed responded more aggressively during the 1980s to inflation than becomes negative in the GI period, but aggressively rises in both before.The real rate turned negative during the inflation of the late periods after 1979. Finally, although oil shocks have transitory effects 1970s, contributing to persistent inflation throughout the decade. on expected inflation in all three time periods, they are more muted However, in the 1980s, monetary policy became much more respon - after 1979 than during the GI period. In fact, the GM period sees an sive, with interest rates rising more sharply to combat high inflation. initial statistically significant decline in expected inflation following an oil shock. Figure 2 shows how one-time, unanticipated shocks to each variable affect public expectations of inflation. 4 These shocks are 1 percent These three responses demonstrate how expectations are shaped by increases for all variables in theVAR except commodity prices, for the Federal Reserve’s response to inflation.When people are confident which a shock represents a 100 percent increase. It is striking to that the Fed will not accommodate inflation, their expectations will not see the differences between the Great Inflation (GI) period, change significantly, thereby making a persistent increase in the first half of 1953 through the first half of 1979, and the Great actual inflation unlikely. Each result is consistent with the idea that the

PAGE 2  EB08-01 Fed’s aggressive interest rate policy after 1979 helped to keep variables, which could be an area of further research. Despite this, responses in expectations temporary and more muted. It also implies “On the Sources of Movements in Inflation Expectations” provides that the Federal Reserve has earned a great deal of credibility since insight into inflation dynamics and suggests that the Fed must seek to 1979. People now are confident that the interest rate response to a monitor expectations to ensure that they do not unhinge and turn into shock will be strong enough to combat inflation, and, therefore, they persistent increases in actual inflation  do not adjust their long-term expectations in response to a one-time shock.This is especially true for commodity price shocks. In the pre- Yash P. Mehra is a senior economist and policy advisor in 1979 sample, commodity price shocks account for between 40 percent the research department of the federal reserve bank of and 50 percent of the variance in expectations. However, after 1979, richmond. devin reilly is a research associate in the these same shocks account for only between 11 percent and 22 percent research department. of that variation.This points to an increased confidence that the Fed will contain inflation even as the public faces higher commodity prices. endnOtes cOncluding thOughts 1 Leduc, Sylvain, Keith Sill, and Tom Stark. 2007.“Self-Fulfilling Expectations and the Inflation of the Mehra and Herrington’s paper uses aVAR including the following 1970s: Evidence from the Livingston Survey.” Journal of Monetary Economics 54: 433-459. variables: expected inflation, actual inflation, commodity prices, 2 short-term interest rates, unemployment, and oil shocks to analyze Mehra, Yash P., and Christopher Herrington. 2008.“On the Sources of Movements in Inflation Ex - pectations: A Few Insights from a VAR Model.” Federal Reserve Bank of Richmond Economic Quarterly the macroeconomic factors that may influence expectations of infla - 94: 121-146. tion, and how these influences have changed over the sample period 3 Hamilton, James D. 2003.“What is an Oil Shock?” Journal of Econometrics 113: 363-398. of 1953 to 2007. During the Great Inflation period, unanticipated shocks to expected inflation, commodity prices, and actual inflation 4 Figures 2 and 3 show the point estimates produced by the model. In their paper, Mehra and Her - all led to sustained and significant increases in expectations. After rington also estimate 68 percent and 90 percent confidence bands. 1979, these responses are more muted, which may help to explain 5 The Great Inflation period discussed in the article includes the subperiod 1953 to 1965, when infla - why shocks after 1979 have not led to persistent increases in inflation. tion was low and stable. The authors included this subperiod to produce more reliable estimates of VAR parameters.

A major source of these changes is the more aggressive response of 6 Ang , Andrew, Geert Bekaert, and Min Wei. 2006.“Do Macro Variables, Asset Markets, or Surveys the Federal Reserve after 1979 to economic shocks that affect Forecast Inflation Better?” Finance and Economics Discussion Series 2006-15, Board of Governors of the Federal Reserve System. expectations. Prior to 1979, nominal interest rates did not rise sufficiently to offset expectations spikes, and thus real rates fell.This accommodative policy allowed for permanent increases in expected inflation, which in turn pushed up actual inflation. However, in the sample periods after 1979, we see a stronger interest rate response following a shock.This kept inflation expectations in check, and strongly influenced the lack of inflation persistence in the post-1979 period. It also suggests that the Fed has gained credibility since 1979, as the general public no longer changes its inflation expectations in response to oil or commodity shocks, since it believes the Fed will not allow those shocks to pass through to actual inflation levels.

Further research could potentially show that the results change when more variables are considered. For instance, Andrew Ang, Geert Bekaert, and MinWei (2006) argue that surveys provide better forecasts of inflation since they may capture information from several sources not summarized by a single model. 6 In addition, aVAR is inherently backward-looking since expectations respond only to past or, at most, current variables.These concerns mean that exogenous movements in expectations may in fact represent overlooked

EB08-01  PAGE 3 figure 1: Var data

1950:1 t0 1979:1 1979:2 t0 2007:1 exPected and actual inflatiOn exPected and actual inflatiOn

15.00 16.00

12.50 14.00 12.00 10.00 e e t t 10.00 a a R R 7.50 n n o

o 8.00 i i t t a a 5.00 fl fl 6.00 n n I I 2.50 4.00

0.00 2.00

-2.50 0.00 1950 1954 1958 1962 1966 1970 1974 1978 1979 1983 1987 1991 1995 1999 2003 2007 Year Year

Actual Inflation Expected Inflation Actual Inflation Expected Inflation

lOg Of cOMMOditY Prices lOg Of cOMMOditY Prices

6.50 6.50

6.00 6.00 e e c c i i r r P P y y t t i 5.50 i 5.50 d d o o m m m m o o

C 5.00 C 5.00 f f o o g g o o L 4.50 L 4.50

4.00 4.00 1950 1954 1958 1962 1966 1970 1974 1978 1979 1983 1987 1991 1995 1999 2003 2007 Year Year

exPected real rate exPected real rate

5.00 8.00

4.00 7.00 ) ) 6.00 % 3.00 % ( ( 5.00 e e t t a 2.00 a R R 4.00 l l a a e 1.00 e 3.00 R R d d e e 2.00 t t 0.00 c c e e p p 1.00 x -1.00 x E E 0.00 -2.00 -1.00 -3.00 -2.00 1950 1954 1958 1962 1966 1970 1974 1978 1979 1983 1987 1991 1995 1999 2003 2007 Year Year

PAGE 4  EB08-01 figure 2: exPected inflatiOn resPOnse tO . . . (continued on Page 6) 1953:1 t0 1979:1 1985:1 t0 2007:1 exPectatiOns shOck exPectatiOns shOck d 1.5 d 1.5 e e t t c c ) ) e e p 1.0 p 1.0 % % x x ( ( E E n n f f o o o o i 0.5 i 0.5 t t e e a a s s fl fl n n n n o o I 0.0 I 0.0 p p s s e e R -0.5 R -0.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period inflatiOn shOck inflatiOn shOck d 0.4 d 0.4 e e t t c c ) ) e e p p % % x x ( 0.2 ( 0.2 E E n n f f o o o o i i t t e e a a s s fl 0.0 fl 0.0 n n n n o o I I p p s s e e R -0.2 R -0.2 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period cOMMOditY Price shOck cOMMOditY Price shOck d d e e t t c

c 20.0 20.0 ) e ) e p p % % x ( x ( E E n f n 10.0 f 10.0 o o o i o i t t e e a s a s fl n fl

n 0.0

0.0 n o n I o I p p s s e e

R -10.0 R -10.0 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

Oil shOck Oil shOck d 0.2 d 0.2 e e t t c c ) ) e e p 0.1 p 0.1 % % x x ( ( E E n n f f o o o o i 0.0 i 0.0 t t e e a a s s fl fl n n n n o o

I -0.1

I -0.1 p p s s e e R -0.2 R -0.2 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period uneMPlOYMent shOck uneMPlOYMent shOck d 1.0 d 1.0 e e t t c c ) ) e e p 0.5 p 0.5 % % x x ( ( E E n n f f o o o o i 0.0 i 0.0 t t e e a a s s fl fl n n n n o o

I -0.5

I -0.5 p p s s e e R -1.0 R -1.0 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

EB08-0 1  PAGE 5 figure 2: exPected inflatiOn resPOnse tO . . . (continued from Page 5) 1953:1 t0 1979:1 1985:1 t0 2007:1 tO interest rate shOck tO interest rate shOck d 0.8 d 0.8 e e t t c c ) ) e e p 0.4 p 0.4 % % x x ( ( E E n n f f o o o o i 0.0 i 0.0 t t e e a a s s fl fl n n n n o o I -0.4 I -0.4 p p s s e e R -0.8 R -0.8 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period figure 3: shOck tO inflatiOn exPectatiOns (continued to Page 7) 1953:1 t0 1979:1 inflatiOn resPOnse exPected inflatiOn resPOnse

3.0

k 1.5 k c c o o

h 2.5 h S S s s

n 2.0

n 1.0 o i o ) i t ) t e a e

1.5 a t g g t c n c n e a e a p

h 1.0 p h

x 0.5 C x C E E f f %

0.5 % ( o o ( e e s 0.0 s n

n 0.0 o o p p s -0.5 s e e R R -1.0 -0.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period nOMinal interest rate resPOnse real interest rate resPOnse

2.5 2.0 k k c c o o h 2.0 h 1.5 S S s s n n

o 1.5 o 1.0 i ) i ) t t e e a a g t g t c n c 1.0 n 0.5 e a e a p h p h x C x C E 0.5 E 0.0 f f % % o ( o ( e e

s 0.0 s -0.5 n n o o p p

s -0.5

s -1.0 e e R R -1.0 -1.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

1979:2 t0 2001:1 inflatiOn resPOnse exPected inflatiOn resPOnse

3.0 1.5 k k c c o o

h 2.5 h S S s s

n 2.0 n 1.0 o o i ) i ) t t e e a

1.5 a t g g t c n c n e a e a p h

1.0 p h 0.5 x C x C E E f f %

0.5 % ( o o ( e e s 0.0 s n

n 0.0 o o p p s -0.5 s e e R R -1.0 -0.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

PAGE 6  EB08-01 figure 3: shOck tO inflatiOn exPectatiOns (continued from Page 6) 1979:2 t0 2001:1 nOMinal interest rate resPOnse real interest rate resPOnse

2.5 k

c 2.0 o k c h 2.0 o S h s 1.5 S n s o 1.5 i ) n t e o

a 1.0 i ) g t t e c n 1.0 a e g a t c p n h 0.5 x e a C E p

0.5 h f x C % E o ( 0.0 f % e o ( s 0.0 n e s

o -0.5 n p

s -0.5 o e p s

R -1.0 -1.0 e R 1 3 5 7 9 11 13 15 17 19 21 23 25 -1.5 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

1985:1 t0 2007:1 inflatiOn resPOnse exPected inflatiOn resPOnse

3.0 1.5 k k c c o o

h 2.5 h S S s s

n 2.0 n 1.0 o o i ) i ) t t e e a

1.5 a t g g t c n c n e a e a p h

1.0 p h 0.5 x C x C E E f f %

0.5 % ( o o ( e e s 0.0 s n

n 0.0 o o p p s -0.5 s e e R R -1.0 -0.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period nOMinal interest rate resPOnse real interest rate resPOnse

2.5 2.0 k k c c o o h 2.0 h 1.5 S S s s n n

o 1.5 o 1.0 i ) i ) t t e e a a g t g t c n c 1.0 n 0.5 e a e a p h p h x C x C E 0.5 E 0.0 f f % % o ( o ( e e

s 0.0 s -0.5 n n o o p p

s -0.5

s -1.0 e e R R -1.0 -1.5 1 3 5 7 9 11 13 15 17 19 21 23 25 1 3 5 7 9 11 13 15 17 19 21 23 25 Period Period

EB08-0 1  PAGE 7