The Fed’s war on inflation is also a battle for the minds of consumers
When Federal Reserve chairman Jay Powell tried to explain the reason for the Fed’s 75 basis point hike on Wednesday, he was essentially targeting two different audiences.
One group was the “Fed-watchers,” investment professionals armed with historical charts that can parse price trends — and so-called dot-plot projections — with a sober eye.
The second (much larger) audience is made up of mere mortals, most of whom are probably stunned by what is going on. After all, as Powell admitted, an entire generation of Americans is “experienced” [inflation] really for the first time”, as inflation like this hasn’t happened in 40 years.
In addition, non-economists usually have only a vague idea of how monetary policy should work. After all, it is much more difficult to determine what a 75bp rate hike really means than to interpret the petrol price displayed on the forecourt of a garage.
This gap in perceptions matters — as Powell himself knows all too well. One of the reasons the Fed raised interest rates this week is that tangible consumer price data emerged last Friday, showing an annual inflation rate of 8.6 percent.
However, the second big, albeit less-notice, trigger was data also released last Friday showing that consumers expect a sharp rise in inflation of 5.4 percent and 3.3 percent over the next one and three years, respectively.
Some economists might answer that the public tends to be very bad at forecasting. Fed officials seem to agree: The governors’ dot plot predictions, constructed with underlying technical models of supply and demand, imply clear future declines in inflation.
It is hoped that the models are correct. But the problem with inflation, as legendary former Fed chairman Paul Volcker often pointed out to friends, is that it can easily take on a life of its own. In other words, expectations become self-fulfilling. Or, to put it another way, Powell is not only fighting a battle in the markets, but also with the mind of the consumer. And that second fight is getting more and more challenging.
To understand why, take a look at the work of behavioral economists like Meir Statman, who have studied the psychology of price increases around the world. As Statman told an inflation symposium in New York this week, consumer reactions to price movements are often biased by five psychological factors.
One is “framing”. Since consumers normally rely on measures such as prices to analyze economic trends, they feel disoriented when “inflation distorts the dollar measure,” Statman says. So they often succumb to the so-called “money illusion”, focusing only on nominal prices and rates, not “real”, inflation-adjusted ones.
The second factor is “anxiety,” which is fueled by this disorientation. The third is “availability”, or the ease with which data can (or cannot) be seen. And the fourth and fifth issue are shortcuts for ‘confirmation’ and ‘representative’. These include people’s tendency to only notice information that fits their pre-existing ideas, and to interpret data by “extrapolating from the recent past to the future.”
All five patterns are now relevant. The rate at which inflation has risen has disoriented many people. In addition, consumers are bombarded by some very “available” (ie visible) figures, such as the 60 percent year-on-year increase in gasoline prices. It’s natural for them to use that as an indication of the broader inflation figure, however imprecise, and project it forward out of fear.
Then there is the issue of the “confirmation bias”. A Pew Survey published in May, found that 70 percent of Americans view inflation as “a really big problem,” far outstripping other concerns. There is, however, a stark partisan division: While 84 percent of Republicans are alarmed about inflation, only 57 percent of Democrats are — let alone presumably facing the same price hikes.
It’s easy to explain: Republican leaders are constantly talking about inflation because they want to attack the White House. That in turn shapes consumer perception. This is important. As Robert Shiller, another behavioral economist, points out, the “stories” we spin for ourselves about the economy don’t just reflect economic reality, they shape it in a self-fulfilling way — even if those stories don’t match macroeconomic models.
So what can Powell do? On Wednesday, he tried to rephrase the popular narrative by constantly using the phrase “price stability” and emphasizing the Fed’s commitment to it. However, he also acknowledged that the central bank is now tracking so-called headline inflation (that is, the gross figure that reflects consumer spending), rather than just “core” inflation, the seasonally adjusted figure to which it usually refers. prefer. This is a sign that the Fed knows that public perception matters.
But the harsh reality is that Powell will struggle to win the battle for the minds of the people — let alone the markets — while $5-per-gallon gasoline is still an easily “available” number. In addition, energy costs cannot be controlled with rate increases of 75 bp. Therefore, he is now determined to keep wage growth in check, even at the cost of higher unemployment. And it’s why America is probably sliding into a period of stagflation — even if that’s not a word Powell would use himself.