Inflation: Managing Expectations

Further to my last post on Inflation and Price Stability in the 3D Universe, I want to expand on the issue of increases in the cost of living.
In recent speeches, Federal Reserve Governor Frederic S. Mishkin, Federal Reserve Governor Randall S. Kroszner, and Federal Reserve Bank of Cleveland President Sandra Pianalto all emphasized the role that long-term inflationary expectations of households play in policy decisions.
Mishkin, March 23, 2007:

According to the Reuters/Michigan survey, long-term inflation expectations of households are currently around 3 percent, as they have been for the past few years. This survey does not specify a price index. However, expectations from the companion one-year-ahead expectations have come in about 75 basis points higher than actual PCE inflation since 1990, suggesting that there may be a systematic bias in the responses to the Reuters/Michigan survey relative to this measure of inflation. If this bias also applies to longer-run inflation expectations, then household expectations may be in line with PCE inflation running in the vicinity of 2-1/4 percent in the long run.

Kroszner, June 1, 2007:

Perhaps most important for the inflation outlook, inflation expectations appear to remain contained. Median long-run inflation expectations from the Reuters/Michigan survey moved up to 3.1 percent in April, but this level is still in the narrow range seen over the past few years.3 Long-run inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities stood at 2.4 percent on May 30 (ten-year, adjusted for carry effect), in the middle of the range observed since the turn of the year.

Pinalto, June 11, 2007:

FRANKFURT (Dow Jones)– Inflation expectations appear to be “well anchored,” but future risks may come from relative price shocks, an extraordinary liquidity crisis and fiscal imbalances, Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, said Monday.
Speaking at an event in Dublin, Pianalto said that she doesn’t regard these risks as imminent, but rather as representative of the risks that central banks face from time to time. To keep inflation expectations low and stable is the common, key target of central banks around the world.
“The reality of rising oil and commodity prices is evident, and my Federal Reserve colleagues and I have been clear that we believe the impact of these influences will dissipate over time,” she said. “But until our beliefs are validated by the data, there is a risk that the public’s trust could erode and inflation expectations could move higher,” Pianalto said.
Talking about financial innovation and integrated financial markets, Pianalto cautioned that “great change rarely proceeds without challenges.”
“We need to explore how best to meet those challenges in ways that will preserve the public’s confidence in our commitment to price stability,” she said.
Repeating earlier warnings, Pianalto said that “if fiscal dynamics don’t improve, central bankers could once again face the difficult challenge of maintaining price stability in a world where expectations are moving in the wrong direction.”

There is obviously no Greenspeak going on here. They know price increases related to food are going to be very sticky. There is plenty of grumbling on Main street.
The reason is corn prices. Yep, the yellow stuff. Instead of driving smaller cars, SUVs are now filling up with ethanol [Story]. The giant sucking sound is of gas tanks competing with the human food chain.
Luckily, Bloomberg reports that “Americans spent 9.9 percent of their disposable income on food in 2005 compared with 22.1 percent in 1949, according to the Agriculture Department.”
While the average North American consumer can probably withstand price hikes related to real food by paring back on corn-based junk such as soda pop, chocolate bars and chips, it is not so for people in other countries like China where the government might begin tapping into the strategic pork reserves [Story]. This is surely a Peter Lynch moment for Fritolay, Coca-cola, Pepsi, McDonald’s, etc.
Still, if I were a central banker, I would remain extremely reluctant to hike rates. To be sure, as Greenspan would say, there are challenges. There is much more to the game than just quashing prices. If only it were that easy.

At the peak of the housing boom in the third quarter of 2005, people were taking cash out of their homes at an annual rate of $709 billion, according to Michael Feroli, an economist at J.P. Morgan Chase & Co in New York. As of the first quarter of 2007, that number had fallen to $178 billion. —

Rate hikes are taking a toll on the economy, and right now, central bankers are probably holding their collective breathes, praying that inflationary and deflationary forces can somehow offset each other.

For new home buyers and those looking to refinance a mortgage, the bond-price jump will likely cause the cost of homeownership to rise. Mortgage rates closely follow the 10-year Treasury. As such, the average rate on a 30-year fixed-rate mortgage has climbed to 6.61% from 6.32% in mid-May. On a $250,000 mortgage, that is the equivalent of adding nearly $50 a month to a mortgage payment. …
For homeowners looking down the barrel of a pending rate adjustment on their ARMs, the pain in your pocketbook could get worse fairly quickly. On ARMs that are just now readjusting, Mr. McBride says rates are set to hit between 7.25% and 7.5%. That will hurt homeowners who, for instance, took out mortgages three years ago when the initial interest rate was 4.5%. For these homeowners, pending payments on a $250,000 mortgage could rise by nearly $450 a month. —

The FOMC is doing what it did in previous junctures: jawbone and let the market tighten rates for them. For now, it might be best to let someone else take a turn at removing the the next block in the Jenga tower.