The Institute for Supply Management’s Prices Paid index is another favored gauge of inflation expectations. It is shown in blue below overlaid on crude oil prices in orange. Energy is a huge input to prices, so it should not be surprising that these two measures track each other closely.
To be fair, the Fed tries to compensate for this by massaging these measures to exclude energy. But does a complicated formula of inflation expectations that captures price movements excluding fluctuations in the cost of energy really align with real world experiences? Tarullo tackled this question:
Some staff at the Fed mentioned to me their impression that a theory giving a prominent role to expectations doesn’t line up too well with how many businesses describe their own method for establishing and changing prices.
Finally, if we assume inflation expectations can be measured, and these measures actually reflect how the world works, does the Fed have any control over them? Is the Fed a mere observer of, or an influence on, inflation expectations?
The Fed adopted a two percent target for the core Personal Consumption Expenditure Index in January 2012. As the chart below shows, they have only hit their target in one month in the last seven years. So, can the Fed manage inflation via expectations? Since they cannot hit their target, the answer appears to be no.
So, where does this leave us? If the Fed has a bad inflation theory, or no theory at all, then they are raising or lowering interest rates thinking they have the power to control inflation. Instead, they might be more like King Canute, the 11th century leader of the North Sea Empire claiming to have supernatural powers as he stood on the beach thinking he controlled the incoming tide. Until the Fed has a working theory of what causes inflation, and a way to measure it, leading to a way to control or influence it, they will remain a modern-day Canute thinking they control what they cannot. Setting monetary policy this way is how mistakes are made.
This article provided by Bloomberg News.