When Jay Powell, Federal Reserve chair, tried to explain the rationale for the Fed’s 75-basis point interest rate increase on Wednesday, he was essentially addressing two different audiences.
One group were the “Fed watchers”, investment professionals armed with historical charts who can parse price trends — and so-called dot plot projections — with a dispassionate eye.
The second (far bigger) audience consists of ordinary mortals, most of whom are probably baffled by what is going on. After all, as Powell admitted, an entire generation of Americans is “experiencing [inflation] really for the first time”, since inflation like this has not occurred for 40 years.
Moreover, non-economists usually have only a vague idea of how monetary policy is supposed to work. It is much harder, after all, to ascertain what a 75bp rate rise really means than to interpret the price of petrol displayed on a garage forecourt.
This gap in perceptions matters — as Powell himself knows only too well. One reason why the Fed hiked rates this week is that tangible consumer price data emerged last Friday showing an annual inflation rate of 8.6 per cent.
However, the second big, albeit less noticed, trigger was that last Friday also delivered data which showed that consumers expect 5.4 per cent and 3.3 per cent inflation rates over the next one and three years, respectively, a sharp increase.
Some economists might retort that the public tends to be very bad at forecasting. Fed officials would appear to agree: the governors’ dot plot forecasts, created with underlying technical models of supply and demand, imply marked future falls in inflation rates.
One hopes the models are correct. But the problem with inflation, as the legendary former Fed chair Paul Volcker often observed 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 just waging a battle in the markets, but also with consumers’ minds. And that second fight is becoming increasingly challenging.
To understand why, consider the work of behavioural economists such as Meir Statman, who have studied the psychology of price rises around the world. As Statman told an inflation symposium in New York this week, consumer reactions to price trends are often distorted by five psychological factors.
One is “framing”. Since consumers normally rely on yardsticks like prices to parse economic trends, they feel disorientated if “inflation distorts the dollar yardstick”, Statman says. Thus, they often succumb to the so-called “money illusion”, where they only focus on nominal prices and rates, not “real”, inflation-adjusted, ones.
The second factor is “fear”, which is fuelled by this disorientation. The third is “availability”, or the ease with which data can (or cannot) be seen. And the fourth and fifth issues are “confirmation” and “representativeness” shortcuts. These include the tendency for people to only notice information that fits their pre-existing ideas, and to interpret data by “extrapolating from the recent past into the future”.
All five patterns matter right now. The speed at which inflation has surged has disorientated many people. Moreover, consumers are being bombarded by some highly “available” (ie visible) numbers, such as the 60 per cent year-on-year rise in petrol prices. It is natural for them to use that as a proxy for the wider inflation rate, however inaccurate, and project it forward, out of fear.
Then there is the “confirmation bias” issue. A Pew survey released in May showed that 70 per cent of Americans view inflation as “a very big problem”, topping other concerns by a wide margin. However, there is a stark partisan split: although 84 per cent of Republicans are alarmed about inflation, only 57 per cent of Democrats are — never mind that they presumably face the same price rises.
It is easy to explain this: Republican leaders are constantly talking about inflation because they want to attack the White House. That, in turn, shapes consumer perceptions. This matters. As Robert Shiller, another behavioural economist, notes, the “narratives” we spin for ourselves about the economy not only reflect economic reality, they shape it, in a self-fulfilling manner — even if those narratives do not match macroeconomic models.
So what can Powell do? On Wednesday, he tried to reframe the popular narrative by constantly uttering the phrase “price stability”, and stressing 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 number, which reflects consumers’ spending), instead of just “core” inflation, the seasonally adjusted figure that it typically prefers. This is a sign that the Fed knows public perceptions are important.
But the hard reality is that Powell will struggle to win the battle for peoples’ minds — never mind the markets — while petrol at $5 a gallon is still a readily “available” number. Moreover, energy costs cannot be controlled with 75bp rate rises. That is why he is now determined to keep wage growth under control, even at the cost of higher unemployment. And it is why America is probably sliding towards a bout of stagflation — even if this is not a word that Powell himself would use.