One of the biggest goals of modern central banking might be completely missing the point

Listen to almost any central banker these days and they are likely to discuss inflation expectations.

Inflation expectations can be tracked by consumer surveys like the New York Fed’s monthly survey or from market-based readings like inflation breakevens.

In the mind of central bankers, keeping inflation expectations at or above their long-term inflation target is important for keeping the economy on track.

The thinking here is that expectations for future inflation will encourage consumers to spend more now in the face of a likely decline in purchasing power.

If inflation expectations decline, then, consumers could be inclined to save money instead of spend it.

And for a global economy — especially in the world covered by the four major central banks: the Federal Reserve, Bank of England, European Central Bank, and the Bank of Japan — that is increasingly reliant on consumer spending, this is a problem.

But research out of Credit Suisse published Wednesday argues that an increase in inflation expectations, which to a central banker would seem to be great news, actually curtails spending unless a corresponding increase in expectations for wage growth follows.

This research, led by Credit Suisse analysts Hiromichi Shirakawa and Takashi Shiono, looks at the difficulty the Bank of Japan is having is pushing economic activity higher with their aggressive monetary policy action (taking rates into negative territory and buying up a huge amount of assets each month).

“Inflation expectations appear to have weakened across the board of late, as real household consumption remains sluggish,” Credit Suisse writes.

“Lack of a robust transmission mechanism from rising inflation expectations to household consumption recovery seems responsible for the prolonged sluggishness of consumption and thus the failure of expected inflation rates to be held up steadily.”

Here’s the major passage (emphasis mine):

The key problem here seems to be the adverse impact of rising inflation expectations on real household consumption. Our regression analysis on household consumption function has actually indicated that a decline in the real interest rate driven by a rise in the expected inflation rate may actually have a negative impact on household consumption. An expectations-driven quickening of inflation appears liable to be a negative for real consumption unless households are reasonably confident in the prospect of faster wage growth.

So, backing this out into plainer English, Credit Suisse’s work finds that unless consumers think they are going to make more money to make up for a gap in their loss of purchasing power, near-term consumption will likely suffer.

At least in Japan, Credit Suisse writes that, “Both employers and employees are not forward-looking enough to make nominal wages reflect changes in inflation expectations.”

So while central bankers (read: economists) want inflation expectations to rise, the consumer and corporate sectors aren’t likely to respond to this change before the psychological damage done by the prospect of higher inflation changes consumer behaviours in a way that negatively impacts the economy.

And this conclusion more or less flies in the face of Fed officials talking about concerns like inflation expectations becoming “un-anchored” — or falling well below the Fed’s 2% long-term target.

Here, for example, is the Fed’s 5-year, 5-year forward inflation expectation rate, which has been declining for the last couple years and has been a topic of concern of the Fed.

Fredgraph (3)

In January, St. Louis Fed president James Bullard said that the drop in inflation expectations was “worrisome,” adding that, “Low inflation expectations may keep actual inflation lower, all else equal, making it more difficult for the Fed to return inflation to target.”

Again, consider the standard economic calculation: lower inflation expectations means consumers won’t be encouraged to spend money now, thus keeping economic growth low.

“Secular stagnation,” which has come to mean lots of things but has become a catch-all for slow economic growth, is really about what happens to economies when there is a lack of aggregate demand: they stall out. So consider this concern over low inflation expectations as the charted equivalent of what a lack of demand looks like.

Now, the other side of this debate is what exactly are market-based inflation “expectations” really measuring, which as we’ve written isn’t exactly, well, inflation expectations.

The Fed’s five-year/five-year breakeven inflation measure isn’t tracking the expected inflation rate for the five years forward measured from five years from now — as the name would imply — but the difference between two interest rates given current levels.

(Going further down this rabbit hole, five-year/five-year breakevens capture the yield at which investors would be indifferent between receiving, for example, the five-year yield now or the five-year yield in the future.)

If all of this seems to be a bit off the beaten path, well, it is.

But the main takeaway is that one of the major projects of modern monetary policy — to push current and expected inflation higher — could be completely missing the point and in fact working against their current goals.

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