Inflation Dynamics and Monetary Policy (Yellen)






Janet L. Yellen

Inflation Dynamics and Monetary Policy

September 24, 2015


You see original and all speech from this link. Keeping inflation stable at a moderately low level is important in 1980’s and 1990’s. Nowadays , this idea is changed because USA needs more and more inflation (same as after the great recession 1930’s)



Firstly, I need to indicate, FED works on (PCE) personal consumption expenditures. This is  the measure of inflation in USA. Please be careful, it is not PCI. FED concentrates core inflation which excludes food and energy prices.

Yellen speaks now. Firstly, we need to take lesson of inflation history.


Today many economists believe that these features of inflation in the late 1960s and 1970s--its high level and lack of a stable anchor--reflected a combination of factors, including chronically overheated labor and product markets, the effects of the energy and food price shocks, and the emergence of an “inflationary psychology” whereby a rise in actual inflation led people to revise up their expectations for future inflation. Together, these various factors caused inflation--actual and expected--to ratchet higher over time.



Yellen more concrete indicated that low inflation may be a indicator of bad economic situation.

United States has experienced very low inflation on average since the financial crisis, in part reflecting persistent economic weakness that has proven difficult to fully counter with monetary policy.



Why does FED use core inflation  ?

Food and energy prices can be extremely volatile, with fluctuations that often depend on factors that are beyond the influence of monetary policy, such as technological or political developments (in the case of energy prices) or weather or disease (in the case of food prices). As a result, core inflation usually provides a better indicator than total inflation of where total inflation is headed in the medium term. As a result, core inflation usually provides a better indicator than total inflation of where total inflation is headed in the medium term. Of course, food and energy account for a significant portion of household budgets, so the Federal Reserve’s inflation objective is defined in terms of the overall change in consumer prices.

What are reasons for core inflation tends to fluctuate around a longer-term trend ?



Such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy—as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship--which likely reflects, among other things, a tendency for firms’ costs to rise as utilization rates increase--represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual.



Movements in certain types of input costs, particularly changes in the price of imported goods, also can cause core inflation to deviate noticeably from its trend, sometimes by a marked amount from year to year.



Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks.


What determines inflation’s longer-term trend?




Theory suggests that inflation expectations—which presumably are linked to the central bank’s inflation goal--should play an important role in actual price setting. Most theoretical versions of the Phillips curve suggest that inflation should depend on short-run inflation expectations, but, as an empirical matter, measures of long-run expectations appear to explain the data better. Estimated trend in inflation is in fact related to households’ and firms’ long-run inflation expectations.


Yellen’s analysis suggests that economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer term trend that is ultimately determined by long-run inflation expectations. Yellen’s  model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations-augmented Phillips curve.

Is there difference between Neo-Clasics and Neo Keynesian on inflation ?

See Tobin (1972) and Friedman (1968) for early discussions of the theory underpinning the expectations augmented Phillips curve. Theoretical descriptions of the inflation process remain an active area of research in economics. In recent years, many economic theorists have used a so-called new-Keynesian framework--in which optimizing agents are assumed to face constraints on price or wage setting in the form of adjustment costs or explicit nominal contracts--to model inflation dynamics. Although these new-Keynesian inflation models can differ importantly in their specifics, they all tend to assign a central role to inflation expectations and resource utilization as drivers of inflation dynamics.

Why anchored expectations are important ?

Situation shown in panel A, in which households’ and firms’ expectations of inflation are not solidly anchored, but instead adjust in response to the rates of inflation that are actually observed. Such conditions--which arguably prevailed in the United States from the 1970s to the mid-1990s--could plausibly arise if the central bank has, in the past, allowed significant and persistent movements in inflation to occur. In this case, the temporary rise in the rate of change of import prices results in a permanent increase in inflation. This shift occurs because the initial increase in inflation generated by a period of rising import prices leads households and firms to revise up their expectations of future inflation. A permanent rise in inflation would also result from a sustained rise in the level of oil prices or a temporary increase in resource utilization. 



Inflation expectations are instead well anchored, perhaps because the central bank has been successful over time in keeping inflation near some specified target and has made it clear to the public that it intends to continue to do so. Then the response of inflation to a temporary increase in the rate of change of import prices or any other transitory shock will resemble the pattern shown in panel B. In this case, inflation will deviate from its longer-term level only as long as import prices are rising. But once they level out, inflation will fall back to its previous trend in the absence of other disturbances. A key implication of these two examples is that the presence of well-anchored inflation expectations greatly enhances a central bank’s ability to pursue both of its objectives--namely, price stability and full employment. Because temporary shifts in the rate of change of import prices or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation.


How can we see inflation expectations ?



11-For households, median long-term expectations from the University of Michigan Surveys of Consumers; for professional forecasters, expectations derived from  survey conducted by Richard Hoey and from the Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia.

2-Difference between yields on nominal Treasury securities and inflation indexed ones, called TIPS.

What do you think Phillips-curve approach to forecasting inflation?

The Phillips-curve approach to forecasting inflation has a long history in economics, and it has usefully informed monetary policy decisionmaking around the globe. But the theoretical underpinnings of the model are still a subject of controversy among economists. Moreover, inflation sometimes moves in ways that empirical versions of the model.

Yellen’s last words:


However, we have not yet fully attained our objectives under the dual mandate: Some slack remains in labor markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal. But I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored.

Dr. Engin YILMAZ
14.10.2017


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