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Bernanke’s fallacy that inflationary expectations are the heart of inflation?
Dr Frank Shostak
In his speech on July 10 the chairman of the Federal Reserve Board Ben Bernanke has suggested that the underlying driving force of the inflationary process is inflationary expectations. (Inflation Expectations and Inflation Forecasting July 10, 2007, speech at the NBER.) For instance, if on account of a sharp increase in the price of oil individuals form higher inflationary expectations this could set in motion spiralling price inflation, or so it is held.
If somehow expectations could be made less responsive to various price shocks then over time this would mitigate the effect of a price shock on price inflation. If we were to accept that inflation expectations are the driving force of the inflationary process is there a way to make these expectations less sensitive to various price shocks?
Bernanke is of the view that by means of suitable central bank policies it is possible to bring peoples inflationary expectations to a state of equilibrium. At this state, he argues, expectations are perfectly anchored or not sensitive to changes in various economic data. According to the Fed chairman once inflationary expectations are well anchored various price shocks such as sharp increases in oil or food prices are likely to be of a transitory nature. This means that over time price shocks are unlikely to have much effect on the rate of inflation so argues Bernanke.
Note that what matters in this way of thinking is the underlying price inflation. It is for this reason that the Fed chairman and many economists are of the opinion that to be able to track the underlying inflation one must pay attention to core inflation — percentage changes in the consumer price index less food and energy. For the time being, Bernanke holds that inflation expectations are still not well anchored. According to his way of thinking as long as individuals are not clear about the precise goal with respect to inflation that policy makers are aiming at it would be difficult to bring inflationary expectations to a state of equilibrium.
So how does one make the policy objective of the central bank clear and credible? By what means can the central bank guide individuals inflationary expectations to a long-term equilibrium i.e. anchor them or make them not sensitive to data changes? Although Bernanke in his speech didn’t say this explicitly indirectly he was referring to inflation targeting. (In his speech he referred extensively to his colleague a Fed governor Mishkin who regards inflation targeting as a key in promoting price and economic stability).
In his speech the Fed chairman said absolutely nothing about the possible role that changes in money might have on inflation. We suggest that without a preceding increase in money supply there cannot be general increase in prices, which is labelled by the popular thinking as inflation.
Can inflation be set in motion without an increase in money supply?
Now what is a price of a good? It is the amount of dollars that is paid per unit of a good. Obviously then for a given amount of real goods if the stock of money remains unchanged the amount of dollars spent per unit of a good will also stay unchanged, all other things being equal. In order then to have a general increase in prices we have to have an increase in the stock of money. Could then inflation expectations cause general rise in prices without the preceding rise in the money supply?
Let us say that on account of a sudden sharp increase in the price of oil people have formed higher inflation expectations. If the money stock remains unchanged then no general increase in prices can take place, all other things being equal. All that we will have here is a situation where the prices of oil and energy related goods will go up whilst prices of other goods and services will go down. Contrary to Bernanke and mainstream economists, we can conclude that it is changes in the money supply that underpin the underlying rises in prices, and not inflationary expectations. Without the support from money supply no general acceleration in price inflation can take place notwithstanding inflation expectations.
Most economists including Bernanke are dismissive of money supply as far as general rises in prices of goods and services are concerned. The main reason for this is that money supply is not well correlated with changes in various price indexes. On account of a variable time lag from changes in money to changes in various price indexes it is not always possible to articulate graphically the importance of money in driving general rise in prices.
What however matters here is not statistical correlation as such but whether it is logically possible to have a general rise in prices without a preceding rise in money supply.
Dr Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 23 June 2007