ECON430-Topic #2: Inflation Expectations and Fed Power

The Federal Reserve cares about what people think inflation will be in the future, and they are typically monitoring future expected inflation by various measures. A recent report by the Federal Reserve Bank of New York shows that inflation expectations are still muted with those surveyed expecting inflation to only be 2.5% over the next year. This is an “all-time low” for the survey–started in 2013–down from only slightly higher levels in the previous year.

inflation-expectations

One-year inflation expectations, in the Atlanta Fed’s firm-level survey-based measure are remarkably stable just at or below 2%, and the Cleveland Fed’s model of ten-year inflation expectations are currently well below 2% per year.

inflation-expecations-two

One other measure of expected inflation compares the difference between returns on 10-year Treasury bonds and 10-year inflation-protected Treasuries (or TIPS). The 10-year breakeven rate has recently been rising, most recently to 1.63 percentage points. However, the level is still well below the Fed’s 2% target.

fredgraph

fredgraph1

For years now, these expectations have been undershooting the Fed’s target for medium term inflation of 2%. In order for the Fed to get back to where they want in terms of output, employment, and inflation, they may have to overshoot their target rate of inflation to get back on track with respect to the price level. The Cleveland Fed also reported last year that measures of inflation are at around 1%, rather far from the Fed’s target, and CPI measures are down below 1%. There are many measures of inflation, and survey-based measures do give some insight on how these expectations are formed and used.

Fed research from St. Louis, suggests these inflation expectations are not all that accurate. A big question might be that we are asking too much (perhaps we expect too much) of the Fed and other central banks. Furthermore, the San Francisco Fed finds that market-based measures do not appear to offer much information about future inflation as one might expect. However, it should be noted that people probably make plans on their investments, and wage setting based on what they expect inflation to be. With that being said, it appears as though the Fed’s inflation expectations play a role in their future policy, as noted by former Fed Chair Ben Bernanke (if you are going to read one thing here, make it the Bernanke article). Bernanke however does believe that there is still room for cutting rates–even today. Others suggest that the Fed and other central banks are out of ammunition or that due to globalization of capital markets there is little central banks can do to influence their own economies.

Issues you might want to address:

  • Why do you think consumer expectations of inflation are so out of line with other measures of inflation expectations? Does it matter that people (i.e., consumers) think of inflation differently than model-based or market-based measures?
  • How do you compare market and survey-based measures of expected inflation? Which ones have historically been more accurate if they have been accurate at all? What other information that is available in survey-based measures gives us any insight about how people plan for inflation in the future?
  • How do you think the Fed “thinks” about inflation expectations? Note that Janet Yellen has mentioned that she believes inflation will meet it’s medium-term target of 2%, given market and survey based measures of expectations simply do not align with that. How well has the Fed been performing on this account? Have they hit their targets in recent years? Or has their policy been ineffective?
  • Please feel free to address any other pertinent questions that are not specifically mentioned here, and feel free to bring in outside sources for help.

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14 thoughts on “ECON430-Topic #2: Inflation Expectations and Fed Power”

  1. In John Maynard Keynes’ Beauty Contest theory introduced in The General Theory of Employment, Keynes draws parallels between financial markets and a hypothetical beauty contest. In the Beauty Contest theory, as in financial markets, outcomes are determined by an aggregation of the public’s expectations. But, outcomes in financial markets often fail to fall in line with expectations derived from consumer and model-based measures. Kevin L. Kliesen of the St. Louis Federal Reserve observes this through the comparison of household inflation expectations and actual inflation, where household estimates exceeded actual inflation by roughly 100 basis points. Kliesen states that shocks from the financial crisis caused this spread between expectations of inflation and actual inflation. What Kliesen is indirectly describing is something that helps to explain the divergence between market expectations and reality, Black Swans. Widely popularized by essayist and scholar Nassim Taleb, a Black Swan is an event that is an outlier, has extreme impact, and is rationalized in hindsight. The financial crisis is one recent example of a Black Swan because it was an outlier, was extremely impactful in that it nearly brought down the U.S. financial system, and has been rationalized since its occurrence. While Black Swans may explain some divergence between populations’ expectations and market reality, Taleb makes a profound point regarding expectations versus reality stating, “[t]he inability to predict outliers implies the inability to predict the course of history, given the share of these events in the dynamics of events.” While aggregate measures of consumer expectations may be useful in that they provide a loose indication of where a certain interest rate or economic indicator may go, the divergence between expectation and reality occurs because even expectations fail to account for all possible scenarios.
    Sources
    1. http://www.nytimes.com/2007/04/22/books/chapters/0422-1st-tale.html?_r=0

    2. http://cas.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf

    3. https://research.stlouisfed.org/publications/economic-synopses/2015/05/06/how-accurate-are-measures-of-long-term-inflation-expectations/

  2. Future long-term inflation expectations can influence the domestic economy in crucial ways. The article by Bernanke states that in the traditional rational-expectations approach the public has full and firm knowledge of the long-run equilibrium inflation rate; and these expectations do not vary over time in response to new found information (Bernanke 2007). One of the main sources of information that people could use is the Fed’s inflation target. The Fed’s inflation target can affect the real interest rate and therefore the level of economic saving and/or investing in a country.
    An article in the economist called “Should the Fed adopt India’s inflation target?” implemented the Fisher Effect as a way to analyze what the target expectation should be. The Fisher Effect is r=i- π where r is the real interest rate, i is the nominal and π is the expected inflation. According this, the higher the expect inflation, the lower the real interest can be.When the economy is in a recessionary period the real interest rate is higher than the real equilibrium rate (this is the rate where inflation is known, not expected) and when the economy is booming then the real rate is lower than the real equilibrium rate. Right now the Fed’s target is at around 2%, there are some who believe this should increase the target to 4% since overshooting the target can free the central bank from a “timidity trap” (Economist 2016). This trap happens when the expected target inflation is low, and then the actual inflation falls shorter than they saw coming. In this problem is the current expected rate is 2% and if the central bank cuts rates to zero, then the real interest rate would fall to the negatives. However if they overshoot their target and fall short, then they are safe.
    Timothy Duy finishes his article stating that “The Fed will not forecast an overshooting, it will not say it is planning an overshoot…” because a higher expected inflation target would only increase the public’s expected inflation rate (Duy 2016), but he also mentions how overshooting the target rate will prove that the expected inflation rate is not a ceiling.

    Sources:
    http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    http://www.bloomberg.com/news/articles/2016-04-07/so-just-how-much-of-an-overshoot-on-inflation-will-the-fed-tolerate
    http://www.economist.com/news/finance-and-economics/21705832-should-fed-adopt-indias-inflation-target-jackson-four

  3. Sam Ford Blog

    The Fed currently has set a target rate of inflation at 2%. However, this target is not feasible for the time being as the Fed has not hit its current targets for the last four years. Not since 2012 have we as a nation hit our target inflation rate (in that year it was 2.1% and in 2011 3.2%). In the last eight years we have failed to hit our target rate six times. Although the Fed has been effective in stabilizing and boosting the stock market in these years, effects on inflation have not been strong. Although Janet Yellen believes inflation (or at least wants us to believe) inflation will hit its 2% target (and as such even states we may need to raise interest rates to curb inflation) current inflation expectations are lower and do not bode well for her prediction as expected inflation expectations at 2.5% which is much lower than normal. Because of the ineffectiveness of the Fed to hit their 2% target it seems time for alternative measures to be taken to raise inflation. One of these alternatives would be of course to raise the target inflation rate. However, when raising inflation targets, it may become very possible that the overshoot is exceedingly high and we may end up with a massive inflation hike. This is seen in other countries such as Brazil that adopted a target inflation rate in 1999 of 4.5 percent and in 2010 help a 5.9% inflation rate. Another method although it has cons as well, is to lower interest rates to a negative level as stated by Bernanke. It may induce spending and growth (although we do not know for sure especially in the long run) which in turn may lead to greater inflation.

    http://www.usinflationcalculator.com/inflation/current-inflation-rates/

    https://www.newyorkfed.org/research/staff_reports/research_papers/9714.html

    http://www.imf.org/external/pubs/ft/fandd/basics/target.htm

    https://www.federalreserve.gov/newsevents/speech/yellen20160606a.htm

    http://www.cnbc.com/2016/09/14/ben-bernanke-says-it-is-premature-to-count-out-negative-rates.html

  4. The effectiveness of the Federal Reserve conducting macroeconomic policy is entirely dependent upon market participants having confidence in their words. In sense, the Fed wills the change of economic variables such as inflation or unemployment through the change of nominal, illusory variables. This has been effective for the Fed in the past but as we approach a decade of unconventional monetary policy (low rates and quantitative easing), the Fed has become a less than reputable source of market confidence as they teeter-totter between hawkishness and dovishness. The dovish component of this precarious equilibrium of ambivalence is a result of steadily low inflation. In attempt to affect this variable the Fed often repeats their manta of ‘we want 2%’ ad nauseam though various outlets that take Chairman Yellen’s words with a grain of salt that is rivaled in size by a college students sodium intake from Ramen noodles.

    This is not to discount the Fed or Yellen’s efforts, as they have been strenuous with maintaining low rates and increasing the size of the Fed’s balance sheet, but at some point one must realize that perhaps nominal variables, in the absence of any material change in policy, cannot be an effective ‘lever’ to control inflation. Whether considering adaptive or rational expectation theories of inflation, the result of the Fed’s actions is the same and equally explicable – i.e. adaptive in that inflation has been below trend for several years now and thus market participants expect more of the same OR rational in that all information is already built in to the rate of inflation so, barring any major unexpected shift in the Fed, low price level changes will persist. Until the Fed can comprehend that more of the same policy will not yield a different result, I believe we will remain in an economic environment where prices are slow to change as a result of a void of market confidence that the Federal Reserve truly knows best AND is acting in the best interest of participants. For now, we are left with the soothing subtly of Janet Yellen’s words:

    “So let me be clear—2 percent is our objective. We want to see inflation go back to 2 percent; 2 percent is not a ceiling on inflation. So we’re not trying to push the inflation rate above 2. It’s always our objective to get back to 2, but 2 percent is not a ceiling. And if it were a ceiling, you would have to be conducting a policy that, on average, would hold the inflation rate below 2 percent.”

    Sources:
    http://www.bloomberg.com/news/articles/2016-04-07/so-just-how-much-of-an-overshoot-on-inflation-will-the-fed-tolerate
    http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    http://www.reuters.com/article/us-usa-fed-inflation-survey-idUSKCN12B1VU

  5. As Bloomberg notes, the Fed is afraid of upsetting anchored inflation expectations by being dovish on short-run inflation. However, due to this fear, the Fed is time-inconsistent and faces a fundamental problem in that it can not reach its inflation target without overshooting the same target but can not communicate that they wish to overshoot. Hence, Yellen is painted into a corner even if there is evidence, also from the Bloomberg article, that Yellen believes the inflation target to be too low by an estimate of 50 bps. Therefore, Yellen’s optimal control theory can not come into play in the current Fed scenario and a target of 2% is a de facto ceiling.
    However, more than communication issues are hurting the Fed’s ability to hit its inflation targets. As Bernanke notes, during the last 30 years long-run inflation expectations have become better, though not perfectly, anchored and there has been a flattening of the Phillips Curve. Taken together, this suggests that people are now less responsive to Fed policy and attempts to set expectations to reach targets. This is reflected in the stable expectations of inflation by the Atlanta Fed’s survey; since 2011 the lowest expectation for year-ahead inflation was 1.7% and the highest was 2.1% with the current being 1.9%. This seems incredible given the rounds of quantitative easing, amounting to $13 trillion, and historically low interest rates. As the Japan Times notes, this indicates that the Fed does not have the power to influence inflation or the economy as much as previously expected. This suggests that the Fed needs more aggressive policies as is reflected in Bernanke’s sentiment that it is too soon to rule out negative interest rates.
    (1). http://www.bloomberg.com/news/articles/2016-04-07/so-just-how-much-of-an-overshoot-on-inflation-will-the-fed-tolerate
    (2). http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    (3). http://www.japantimes.co.jp/opinion/2016/09/20/commentary/world-commentary/fed-prisoner-exaggerated-expectations/#.V_1WcXpe7nM
    (4). http://www.cnbc.com/2016/09/14/ben-bernanke-says-it-is-premature-to-count-out-negative-rates.html

  6. The Fed has set the inflation target at a somewhat arbitrary 2% – a level which they believe will walk the line between teetering towards deflation while still giving the public a low rate which promotes efficient “longer-term economic and financial decision making.”(1) They aren’t going to necessarily be able to consistently hit a perfect 2% every period, but in analyzing the core PCE over the last 5 years the Fed has generally maintained a steady level of inflation that has fluctuated just below the Fed’s target at range of 1.3% to 2.1%, achieving a range near their goal (2)
    As Joe Brusuelas commented, “Inflation has long and variable lags” which require the Fed to hike rates now to prevent high inflation in the future. (3) The Fed reinforces this by citing that their goal isn’t to affect inflation now, but to “maintain an inflation rate of 2 percent over the medium term.” (1) Therefore, one can expect the Fed to raise rates before meeting their 2% target, as they did in December 2015 when Core PCE was around 1.4%. The Fed has a difficult job, as many Americans probably have no idea what inflation should be and inherently think it’s a bad thing because it causes the value of their money to deteriorate, if they even realize what inflation does to the value of their money. (4,5) That’s not so bad, as long as businesses have a better idea since they are making larger expenditure decisions. But as Ylan Mui of the World Economic Forum points out, a survey of business owners in New Zealand shows a clear disconnect between business owners’ expectations and the central bank’s target as well. (6) The Fed is doing the best they can and has had success in achieving an inflation rate that is just above a deflationary level, but they can’t fix ignorance on the part of market participants.

    1 – https://www.federalreserve.gov/faqs/economy_14400.htm
    2 –
    https://fred.stlouisfed.org/series/PCEPILFE
    3 –
    http://www.usnews.com/news/the-report/articles/2015/09/16/ask-an-economist-should-the-federal-reserve-raise-interest-rates
    4 –
    http://www.businessinsider.com/americans-think-inflation-is-way-higher-than-it-really-is-2013-10
    5 – http://www.councilforeconed.org/cel/WhatAmericansKnowAboutEconomics_042605-3.pdf Page 41
    6 –
    https://www.weforum.org/agenda/2015/09/how-much-do-people-really-know-about-inflation/

  7. The Fed attempts to achieve its goal of expected inflation by using instruments such as open market operations to moderate interest rates. These instruments are used to influence opinion of the population so that their actions will reach the Fed’s goals. Ben Bernanke, former chairman of the FOMC, described the necessity for these goals to be anchored as people vary their investment patterns and consumption as inflation changes. When the Fed is capable of managing people’s expectations around the anchor, then it is much easier for the Fed to reach these goals. Recent surveys from Fed banks around the country show expectations have regressed towards the feds anchored goal. The New York Fed reported expected inflation to be declining towards 2.5% while the Atlanta Fed has reported steady inflation just below 2%. However other mathematical models strongly differ and say that expected inflation is well below the anchored 2%. Bernanke points out that the mathematical models do not account for external factors affecting the Fed due to an increasingly globalized economy. Because these models do not account for how other countries savings and investment decisions can affect the Fed’s ability to move interest rates, it may appear as if the Fed is failing to stay near the anchor. In reality surveys show that the Fed is actually moving towards the 2% anchor meaning the Fed is effectively managing consumer expectations. Since the fed is able to conform consumer’s thinking to their own, it makes it much easier for the Fed to reach its targets.

    http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    https://www.frbatlanta.org/research/inflationproject/bie.aspx
    http://www.reuters.com/article/us-usa-fed-inflation-survey-idUSKCN12B1VU

  8. We can rely very little on market or survey based measures of inflation. Market based measures using TIPS are really only a strategic tool in long term of 5 or 10 years. They are highly correlated with past inflation which tends to increase their prediction error in the short run. No change and survey based measures are the most accurate in one year forecasts according to Michael D. Bauer and Erin McCarthy, even though they still on average have an error of 1.5-1.75 percent. The best prediction of interest rates is a constant one that matches the Fed’s target of 2%. The reason for this might be that no matter what as long 2% is the target whether or not Janet Yellen overshoots, undershoots, or any other method she decides, the law of averages keeps the constant rate of prediction at 2%, the closest to the actual rate in recent years. Granted that this could be due to the volatility of interest rates were extreme when collected (Great Recession). However, survey based measures for 5 -year predictions compared with the market based measures for 5- year predictions were both over the real 5-year inflation percentage according to a chart by Kevin L. Kliesen. Market based tend to be more accurate in the long term as mentioned earlier due to correlation with past trends. This makes perfect sense considering surveys of households would not be nearly as educated or pay as close attention to interest rates over a longer length of time. The survey based measures tell us that in the long term people over plan for high inflation rates which most likely impacts how they are currently spending their money (or lack thereof) in the present. Considering part of the reason the FED announces interest rates whether they are or are not overshooting is based on managing the publics expectations. It is the FED’s version of trying to stay consistent by playing a sort of game. Much like if students won a prize for a game and the game was to have everyone in a class room guess ½ of the class average on a scale of 1-100. Educated individuals would consider that most people would pick a number in their heads where the average would result in 50 meaning that their classmates would write down 25 as half of the average. Knowing this the intellectual person takes into account that the answer everyone wrote down would be 25 making the actual half of the class average roughly 12. The FED uses these flawed predictions of surveys of their “wrong” targets to achieve and guess the actual amount, or the amount they prefer it be. The reason why people might be guessing lower is due to higher education. Those taking the surveys then would be wising up to the game being played. The market based surveys would then look less accurate in the future considering they make their predictions off of historical figures. They would not be considering the publics new outlook causing market based measures to have a greater error in long term predictions of interest rates.
    1.http://www.frbsf.org/economic-research/publications/economic-letter/2015/september/market-based-inflation-forecasting-and-alternative-methods/
    2. https://research.stlouisfed.org/publications/economic-synopses/2015/05/06/how-accurate-are-measures-of-long-term-inflation-expectations/
    3. William Woods 345 class
    4. http://www.bloomberg.com/news/articles/2016-04-07/so-just-how-much-of-an-overshoot-on-inflation-will-the-fed-tolerate
    5. http://www.aaii.com/investing-basics/article/the-top-10-economic-indicators-what-to-watch-and-why
    6. http://www.reuters.com/article/us-usa-fed-inflation-survey-idUSKCN12B1VU

  9. With the goal of achieving maximum employment and price stability, the Fed set a long-term inflation target (currently 2%) that if reached, will yield the maximum amount of output at a sustained price level. Despite the positive recovery in employment and constant low interest rate since the last recession, inflation has remained below the Fed’s long-run inflation expectation.

    The Fed must be constantly monitoring households’ short-term expected inflation through market-based forecast or professional forecaster because as Bernanke points out, an accurate forecast of the very near-term inflation will provides a better jumping-off for the longer-term forecast [Bernanke, 2007]. And second, because the difference between current rate and inflation target rate will likely affect interest rates and short-run total output.

    Analyzing the fillips curve we can notice that current inflation depends not only on proportions by which short-run output changes and proportion changes in prices shocks such as oil, but it also depends on the expected inflation by households about that period. Consequently, this will affect total production and interest rate in the short-run, depending on how sensitive is the slope coefficient for a given change in the difference between current and target inflation and interest rate.

    Finally, efficiency of current monetary policy tools should be subject of examination, but there might be other variables that should be included in the analysis of why inflation has constantly remained below the long-term inflation expectation even though low interest rates. For instance, Robert Samuelton states that because of the severity of the last recession, businesses leaders and households have become more protective and precautionary, and they save more and spend less [Samuelton. R]. This could be one of many answer of why inflation has remained lower than inflation target despite the constant low interest rate.

    1. http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    2. http://www.japantimes.co.jp/opinion/2016/09/20/commentary/world-commentary/fed-prisoner-exaggerated-expectations/#.V_1WcXpe7nM
    3. http://www.frbsf.org/economic-research/publications/economic-letter/2015/september/market-based-inflation-forecasting-and-alternative-methods/

  10. Households and businesses judge their inflation expectations differently than what the Fed uses, such as model-based or market-based measures. Households’ take into account past decisions the Fed has made and historical events. For example, due to the Great Recession debt levels have risen, this has caused households and business to save more and invest less even though data shows the economy is in a better place to invest (1). This is a problem for the Fed, because now what it should do to hit its target inflation rate does not work because debt recovery is harder to mend than normal economic cycles. Another reason why consumer expectations of inflation are not aligned with other measures is because households like to prepare for the worse, while hoping for better. For inflation they do this by expecting higher rates even if data says otherwise. Household’s belief in the credibility of the Fed can directly affect how much households want to prepare, with them preparing less when they believe the Fed is more credible and preparing more when less credible (2). Recently households’ belief the Fed to be less credible, mainly in part to the Great Recession, causing people to expecting higher inflation. Consumers’ expectation of inflation is not aligned with that of other measures and this causes problems for the Fed in how it makes it decisions.

    Sources:
    1. http://www.japantimes.co.jp/opinion/2016/09/20/commentary/world-commentary/fed-prisoner-exaggerated-expectations/#.WAVz3LkieUm
    2. https://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2016/lacker_speech_20160321

  11. Inflation can be a double-edged sword. The Fed wants inflation to be higher because in the short run this will spur the economy, causing job growth and an increasing output, but they have to be careful not to run inflation too high and ruin people’s expectations of inflation. This being said, in the current state of the economy, the Fed has had trouble getting inflation to rise, even by cutting rates for a significantly long time. According to Bloomberg, inflation expectations are the lowest they’ve been since mid 2013. The Fed continues to be optimistic about this, with the Vice Chairman Fischer citing the cause to be the drop in oil prices. However, if they were to be pessimistic about the inflation expectations, these expectations could get even lower, which brings us to a catch-22. Why is the Fed to be trusted when consumers know that they will always be promoting the future of the economy? Consumers might start to not trust the Fed, making their actions less effective. As Bernanke states, our inflation expectations are imperfectly anchored. The Phillips curve has become flatter, or less sensitive to changes in inflation. Perhaps this is more evidence that the Fed is simply out of tools to spur the economy. With no signs of inflation growth, the Fed has no incentive to raise rates. The Fed wants to raise rates after this long period of stagnant low rates, but due to the lack of inflationary signs, they are weary. When consumers distrust the Fed, it makes it hard for them to affect real output.
    (1) http://www.bloomberg.com/news/articles/2015-09-14/u-s-inflation-expectations-lowest-in-years-fed-survey-shows
    (2) http://www.federalreserve.gov/newsevents/speech/bernanke20070710a.htm
    (3) http://www.reuters.com/article/us-usa-fed-inflation-survey-idUSKCN12B1VU

  12. When attempting to forecast something as influential in the economy as expected inflation rates, there exist two main measures which are used by central banks for analysis of the inflation outlook and and the risk that encompasses it. The two forecasts under consideration in this instance being market-based measures, which are calculated from financial securities and survey-based measures, which are surveys asking professional forecasters to account for all available information and make predictions on expected future inflation. The differences between the two arise from the way they interpret available information. While market-based measures are available at a high frequency, they also take into account many idiosyncratic factors that change price but do not relate to expectations. Two market-based measures most taken into account are TIPS break even inflation rates and Inflation swap rates, both of which include expectations for headline CPI inflation. Forecasts produced by the Survey of Professional Forecasters (SPF) also are based off of headline CPI inflation, but look at the predicted data for the upcoming year. Thus, the two measures are difficult to compare unless the survey-based measures are lagged by one year. In the Bauer and McCarthy article, they impose the aforementioned constraint onto the SPF forecasts and after comparing the results, conclude that survey-based measures historically offer a more accurate representation of expected inflation. One disclaimer about this could arise from the fact that the data available for market measures doesn’t go back as far as SPF data does, but the inclusion of shorter-term inflation expectations and the wide distribution of SPF participants provide a worthy rebuttal as to why the survey-based measures should provide a better forecast.

    https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1865.en.pdf
    http://www.frbsf.org/economic-research/publications/economic-letter/2015/september/market-based-inflation-forecasting-and-alternative-methods/
    https://www.clevelandfed.org/en/newsroom-and-events/publications/economic-trends/economic-trends-archives/2010-economic-trends/et-20100405-survey-based-measures-of-inflation-expectations.aspx

  13. The Federal Reserve as it aims for a target rate of inflation rate, will conduct research in order to gauge consumers’ expectations of inflation through surveys and through models, as a role of the Fed is manage expectations of the economy. Reviewing the survey results provided by the New York Fed had interesting results as most months report that the three-year expectation tends to be higher than the one-year expectation. In our culture we tend to have a negative connotation with inflation, as it is a force that will decrease the value of nominal assets, as it is viewed to be something to avoid at all costs, which may influence the survey results. Consumer’s reactions noted by Keynes by the theory of “animal spirits” where people may act on impulse depending on prevailing market conditions may have influenced responses on the survey as well. Paired with many different models by the Federal Reserve, which will use the value of different indicators in the market such as bonds and treasury securities. These models exhibit the risk in which people are willing to invest in such bonds and the returns they receive as TIPS, Treasury Inflation Protected Securities, bare payouts indexed to inflation. Consumers act with the assumption that their dollar will be worth more now than in the future. It may be important as this difference exists between the models and the survey as this may lead to an unexpected change as people constantly reevaluate their expectations based on abrupt changes where a model may lag or show a less dynamic indicator of actual expectations.

    https://www.frbatlanta.org/research/inflationproject/bie.aspx
    https://www.clevelandfed.org/our-research/indicators-and-data/inflation-expectations.aspx
    http://www.reuters.com/article/us-usa-fed-inflation-survey-idUSKCN12B1VU
    http://www.bloomberg.com/news/articles/2015-09-14/u-s-inflation-expectations-lowest-in-years-fed-survey-shows

  14. The Fed’s primary objective is to act as a last resort lender in times of crisis, stabilizing the natural peaks and troughs of an economy through monetary policy. It attempts to influence people’s and firms’ demand for goods and services by raising or lowering the federal funds rate (the interest rate at which banks can borrow and lend with each other). When in a recession the Fed lowers the federal funds rate, allowing commercial banks to lower their own interest rates in hopes of attracting borrowers. The story dictates that lower interest rates will encourage consumers to demand more goods and services that will, in turn, increase inflation and price levels. For the most part though, a consumer’s demand for goods and services is related to the real interest rate (the nominal interest rate minus the expected inflation). This means that consumers make choices today based on the nominal interest rate and what they expect inflation to be in the future. Changes in real interest rates affect the public’s demand for goods and services by altering borrowing costs, availability of bank loans, wealth of households, and foreign exchange rates (1). Assuming this rational holds, the enactment of any monetary policy, whether it be expansionary or contractionary, is followed by a subsequent change in inflation levels. With an increasing number of people storing their wealth in the form of financial assets and deposits, the Fed should theoretically hold a tremendous amount power to alter an economy. However, after years of failing to hit its inflationary target of 2% in a stagnant economy, economists have begun to raise questions about the Feds ability to engineer an economic recovery (2). But what if the Fed’s inability to change inflation to its desired level stems from the publics ignorance of financial markets?

    In a world where the economy is heavily influenced by consumers’ future expectations, less than half of the world population is financially literate. The OECD conducted a global financial literacy survey intended to test one’s knowledge, through a series of multiple choice questions, of basic financial knowledge, attitudes, and behaviors. With over 52,000 people across 30 countries participating in the survey, the results were concerning. The average score was a 13.2 out of 21 (63%) possible points (4). Another survey was conducted in 2014 by the Global Financial Literacy Excellence Center at George Washington University aimed at evaluating fundamental concepts in financial-decision making: basic numeracy, knowledge of interest rates, interest compounding, inflation, and risk diversification. More than 150,000 randomly selected adults in more than 140 countries were interviewed for this survey, producing comparable results to the OECD’s survey. The survey concluded that only 33% of adults worldwide are financially literate, while only 57% of adults in the United States are financially literate(3). Because of a lack of knowledge about finance and financial products, many people are left unable to access banking and financial services, and therefore are kept out of financial markets.

    The Fed operates strictly on the market for bank reserves, but can indirectly affect the value of financial assets by changing the federal funds rate. With half of the adult population being financially illiterate coupled with the fact that 36% of Americans feel anxious about their financial situation and would rather save than spend (5), the US economy has struggled to reach the levels of output it enjoyed before the Great Recession of 2008. The lack of financial security, coupled with a lack of understanding of financial markets, refrains consumers from participating in various markets in the economy and is consequently hindering the Fed’s ability to fix the economy.

    Works Cited:
    (1) http://www.frbsf.org/education/teacher-resources/us-monetary-policy-introduction/real-interest-rates-economy/
    (2) http://www.japantimes.co.jp/opinion/2016/09/20/commentary/world-commentary/fed-prisoner-exaggerated-expectations/#.WAZtA-h96hd
    (3)http://gflec.org/wp-content/uploads/2015/11/3313-Finlit_Report_FINAL-5.11.16.pdf
    (4) http://blogs.wsj.com/economics/2016/10/12/financial-literacy-is-still-abysmal-everywhere/?mod=e2twe
    (5) http://www.marketplace.org/2016/10/13/economy/why-economic-anxietys-rise

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