Are inflationary expectations the heart of inflation?

For most economic commentators the underlying driving force of inflation is inflationary expectations[1]. For instance, if there is a sharp increase in the price of oil, individuals may form higher inflationary expectations that could set in motion spiraling 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, it is argued.

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?

Most commentators are 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 it is held expectations are perfectly anchored or not sensitive to changes in various economic data.

According to various economic experts once inflationary expectations become 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.

Note that what matters in this way of thinking is the underlying price inflation. It is for this reason that Federal Reserve policy makers and many economists are of the view 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.

To make inflation expectations well-anchored individuals must be clear about the monetary policy of central bank policy makers. According to this way of thinking as long as individuals are unclear 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.

For most commentators by means of inflation targeting and clear communication by policy makers, the central bank could make inflation expectations well – anchored i.e. make them not sensitive to data changes.

Can inflation be set in motion without an increase in money supply? 

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.

A price of a good is the amount of dollars paid per unit of a good. For a given amount of goods, if the stock of money remains unchanged the amount of dollars spent per unit of a good will stay unchanged, all other things being equal.

Let us say that because 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 the prices of other goods and services will go down.  (If more money spent on oil and oil products obviously that less money left for other goods and services – note again a price is the amount of money per unit of a good).

We can conclude that changes in the money supply underpin the underlying rises in prices, and not inflationary expectations. Without the support from money supply, all other things being equal no general increase in price inflation can take place notwithstanding inflation expectations.

[1] Ben S. Bernanke “Inflation Expectations and Inflation Forecasting” July 10,2007, speech at the NBER.