Inflationary Expectations and Wage-Price Spirals

by: Mark Thoma

I think raising interest rates to combat inflation is unnecessary. The increase in prices behind the run-up in inflation is largely driven by real rather than monetary factors, and once the adjustment in relative prices has stabilized at a point that balances global commodity demands and supplies, and once the adjustments have passed through the system, prices will stabilize.

In addition, at this point, there are no signs of a wage-price spiral. But I also think cutting interest rates (e.g.) would be a mistake as this would risk creating inflationary expectations that become self-fulfilling, i.e. it would potentially undermine the Fed's inflation fighting credentials and risk generating the wage-price inflation spiral we wish to avoid:

Why those ‘expectations’ matter, by Samuel Brittan, Commentary, Financial Times: The words “inflationary expectations” must by now be familiar to every newspaper reader... Yet a few years ago they were unknown outside specialist circles. ...

They appeared in academic debate as early as the 1970s and 1980s in relation to the so-called monetarist controversy. The key contention of the monetarists was not about the need for money supply targets, as technocrats assumed, but that monetary policy rather than direct intervention in wage or price setting was the right method of tackling inflation. Their opponents believed that this could only work by creating a slump in which millions would lose their jobs. The more thoughtful monetarists did not deny that there was a transitional cost in squeezing inflation out of the system. But the severity of that cost would depend on how credible the policy was. If the main economic actors believed that policymakers would stick to their guns, they would base their actions on the assumption of modest inflation and would frame their behaviour accordingly and settle for moderate increases in pay and prices. If on the other hand they expected the policy to be eventually abandoned, any monetary squeeze would indeed have its main effect in reduced output and employment.

These contentions have been the basis of policy in many countries, at least for the past decade and a half. ... Higher prices for energy, food and imports are pushing consumer price index inflation well above ... target and will continue to do so well into 2009 and thus exert a downward pressure on living standards and real wages. Yet “these increases in commodity prices cannot by themselves increase sustained inflation unless other prices begin to rise at a faster rate. And it is the task of the monetary policy committee to ensure that they do not.” If it succeeds, the reduction in living standards will be a one-off affair... What is surprising is not that inflationary expectations have increased after recent shocks, but that they have increased so little, especially for the medium term...

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