Just How Are Those Inflation Expectations Set?

Consumer and investor expectations for inflation are so important that Federal Reserve Chairman
Ben Bernanke mentioned them 17 times at his first-ever news conference. Congress has charged
the Fed with maintaining price stability, so it is understandable that the Fed Chairman would
watch inflation expectations closely.

The problem is that economists are not certain how inflation expectations are formed, which
stymies efforts to influence those expectations.

Research by Harvard Economics Professor Greg Mankiw found that consumers and investors
often have widely different expectations for inflation and often base those expectations on only
narrow aspects of economic news. Even with these limitations, many experts contend that these
expectations cannot be ignored

In an email, Mankiw writes, "[Inflation expectations] matter because they affect behavior, even
if people are not fully rational in forming their expectations. But it is surely a topic about which
reasonable economists can disagree."

One of those disagreeing economists is Wrightson ICAP's Lou Crandall. Crandall says, "One of
the biggest criticisms of the way the Fed talks about its policies is that it seems to have this very
rigid, unrealistic notion of what inflation expectations are and how they operate. I don't think
they are inflation expectations, I think they are only inflation anxieties."

Crandall says Bernanke and others should factor inflation expectations into their decisions in "a
general way," rather than relying on a specific number derived from a survey.

However inflation expectations are set, Chairman Bernanke is determined to see that they
remain "well anchored," even if it is not always clear what they are anchored in.

Source: http://www.pbs.org/nbr/blog/2011/05/just_how_are_those_inflation_e_2.html

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