Mark Thoma quotes Federal Reserve Governor Rick Mishkin on the changing dynamics of inflation:
Economist's View: Frederic Mishkin: Inflation Dynamics: Anchoring of inflation expectations is not a deus ex machina. It must come from somewhere, and since Milton Friedman’s adage that “[i]nflation is always and everywhere a monetary phenomenon” is still true, monetary policy must be the source of the change in the evolution of long-run inflation expectations. During the 1960s and 1970s, the Federal Reserve and a number of other central banks maintained a policy stance that, inadvertently or not, was too easy... allowed both actual and expected inflation to drift up markedly.... Since the late 1970s, however, the Federal Reserve and many other central banks have increased their commitment to price stability.... The Fed pursued preemptive strikes against rises in inflation in 1994-95, 1999-00, and in 2004-06, as well as preemptive strikes against potentially deflationary forces in the fall of 1998 and in 2001-04. The result has been not only low and stable inflation but also, as we have seen, a strong anchoring of long-run inflation expectations.
The... achievement of anchored inflation expectations can also help explain the other stylized facts.... With expectations of inflation anchored, any given shock to inflation--whether it is from aggregate demand, energy prices, or the foreign exchange rate--will have a smaller effect on expected inflation and hence on trend inflation... [and] a much less persistent effect on actual inflation. The recent experience with surging oil prices seems consistent with this story....
Jean Boivin and Marc Giannoni (2006), and... John Roberts (2006) at the Federal Reserve Board... suggest that changes in the way the Federal Reserve conducts monetary policy--including changes in both the parameters of monetary policy reaction functions and the volatility of shocks to those functions--may account for most of the reduction in the coefficients on resource utilization in traditional Phillips curves....
[T]his one explanation covers so many of the stylized facts--an application of Occam’s razor. Indeed, I have always become more confident in a theory if it can explain a number of very different facts. This is why I am so attracted to the view that inflation expectations are a key driving factor in the inflation process. Of course, many other factors also influence inflation, and some of these provide other possible explanations for the recent changes in inflation dynamics....
These stylized facts--that inflation has become less persistent and now responds less to aggregate demand and supply shocks--can lead to inappropriate policy advice. If we take these facts to be structural... we might interpret them as suggesting that the Federal Reserve could respond less to shocks and yet be confident that inflation would remain at a low level.... [But] if we instead attribute the observed changes in inflation dynamics to better monetary policy and a resultant better anchoring of inflation expectations, then such policy conclusions are unwarranted....
[A] key benefit of establishing a strong nominal anchor... [is that] expectations now behave in a manner that makes the economy more stable to begin with.... [C]yclical movements in interest rates need not be as great as was necessary when expectations were unanchored.... At the Federal Reserve, we understand the importance to the health of the economy of anchoring inflation expectations. This is why Federal Reserve officials continually reiterate our commitment to maximum sustainable employment and price stability, why we have been willing to make preemptive strikes against both inflationary and deflationary pressures, and why we remain vigilant....
I have argued here that the most attractive explanation for recent changes in inflation dynamics is that expectations have become better anchored.... What implication does this have for forecasts of future inflation?... If we turn to the financial markets, we find that inflation expectations extracted from a comparison of the yields between Treasury inflation-protected securities (TIPS) and standard Treasury securities seem consistent with an anchor at or perhaps a little above 2 percent... In the case of households, long-term inflation expectations from the Reuters/Michigan survey have been running much higher for a number of years, at around 3 percent...
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