The concept of inflation has been a constant thorn in the side of central bankers. Although price stability is one of the main goals at many central banks, inflation targeting has proven a difficult exercise. Many central bankers have gone as far as questioning whether economists even understand the drivers of inflation. Without understanding its basic building blocks, how can central banks be expected to control inflation?
Most recently, Bank of Finland head Olli Rehn called for the European Central Bank to conduct a review of its inflation policy:
The deviation of inflation expectations from the ECB’s target is worrisome in terms of the effectiveness of, and strategy for, monetary policy…the ECB must prepare itself for longer-term challenges which would necessitate a review of its monetary policy strategy – that is, a re-examination of the principles, key assumptions and instruments underlying its monetary policy.
The U.S. Federal Reserve felt a similar need for a re-examination of monetary policy and is conducting a year-long “Fed listens” tour. Undoubtedly inflation will be one of the top topics discussed. As Chairman Jerome Powell explained a few weeks ago:
My colleagues and I on the FOMC are undertaking a year-long review of the Federal Reserve's monetary policy strategy, tools, and communication practices. These will include town-hall-style meetings and a conference where academic and nonacademic experts will share their views. These events will inform staff work and FOMC discussions as we plan for the future.
Perhaps the most critical account comes from former Fed governor Daniel Tarullo. In a piece for the Brookings Institution in October 2017 titled “Monetary Policy Without A Working Theory of Inflation,” Tarullo questioned whether the Fed even has a viable theory on inflation dynamics:
The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making.
In light of these critiques, Powell’s comment on inflation last month was rather interesting:
In our thinking, inflation expectations are now the most important driver of actual inflation.
So, the Fed indeed has a theory on what drives inflation! The problem with inflation expectations is that they are unobservable and difficult, if not impossible, to measure. Our concern is that “inflation expectations” are often little more than a reflection of swings in energy prices. As the chart below shows, breakeven rates on Treasury Inflation-Protected Securities often move in lockstep with crude oil prices.