The Federal Open Market Committee’s expectation that economic conditions are likely to warrant exceptionally low levels of the federal funds rate “for an extended period” is conditional on three things: low rates of resource utilization (an elevated unemployment rate and a low level of capacity utilization), subdued inflation trends, and stable inflation expectations.

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Weekly Commentary by Dr. Scott Brown
Inflation Expectations
June 14 – June 18, 2010
The Federal Open Market Committee’s expectation that economic conditions are likely to warrant exceptionally low levels of the federal funds rate
“for an extended period” is conditional on three things: low rates of resource utilization (an elevated unemployment rate and a low level of capacity
utilization), subdued inflation trends, and stable inflation expectations. Federal Reserve policymakers will have to abandon the commitment to
exceptionally low rates at some point, initially moving toward a more normal, but still accommodative, stance. However, the outlook for the Fed’s
three conditions is unlikely to change anytime soon. Economic growth is not expected to be strong enough to push the unemployment rate down
significantly, the trend in inflation is likely to remain benign, and despite some worries about accommodative Fed policy and large federal budget
deficits, inflation expectations are also likely to remain low.

2. Why are inflation expectations important to the inflation process? The idea is that workers will ask for larger wage increases if they expect more
inflation. Businesses will try to raise their prices more. Yet, most firms tend to base annual wage adjustments on what the CPI was over the previous
year, and firms have continued to generally report a limited ability to raise prices. In the Great Inflation in the late 1970s and early 1980s, higher
inflation expectations had become embedded in the labor market – that’s not happening currently.

3. Inflation expectations can be gauged in a number of ways. There are survey measures, such as polls of economic forecasters or the general public.
Or one can look at market-based measures, such as the spread between inflation-adjusted and fixed-rate Treasuries. Recent polls, such as the
Philadelphia Fed’s Survey of Professional Forecasters or the University of Michigan’s Consumer Sentiment survey, suggest that inflation
expectations remain well anchored. Market-based measures have also shown no significant increase, although recent figures may be biased by the
short-term flight to safety in Treasuries.
Recently, the Cleveland Fed published research* on a new way to look at the components of the Consumer Price Index. Prices of some components,
such as gasoline and food, change frequently depending on short-term variations in supply and demand. Other prices, such as personal services and
rents, change infrequently. The authors split the CPI into “sticky-price” and “flexible-price” aggregates. No surprise, the “sticky-price” CPI tends to
be much more stable and the “flexible-price” CPI tends to bounce around the “stable-price” CPI. The authors conclude that the “flexible price” CPI
responds to changing market conditions, “including the degree of economic slack.” The “sticky-price” CPI “seems to contain a component of
inflation expectations.” The “sticky-price” CPI rose 0.9% over the 12 months ending in April (vs. +2.6% y/y a year earlier), suggesting relatively
mild inflation expectations.
*
Are Some Prices in the CPI More Forward Looking than Others? We Think So, by Michael F. Bryan and Brent Meyer.