10/11 00:01

U.S. Economy: Fed's Worry Is Whether Inflation Scares Consumers

By Noam Neusner

Washington, Oct. 11 (Bloomberg) -- The Federal Reserve is taking on a new role: economic psychologist.

Last week, the Fed's policy-setting Open Market Committee said it would monitor consumers' expectations about inflation as higher energy costs start to seep through the economy. If gasoline prices are making you think of asking for a raise, the Fed wants to know. If higher home heating costs change your view on saving, the Fed is concerned.

Worrying about the psychology of households is a long way from the usual monetary policy headaches, such as setting targets for the money supply or identifying the optimal unemployment rate for non-inflationary economic growth. Yet it is a critical concern if the Fed wants to steer the economy into an 11th year of expansion without letting prices accelerate.

``If you think prices are going to go up tomorrow, you buy today, and that in fact can cause the prices to go up tomorrow,'' said Paul Kasriel, chief U.S. economist at Northern Trust Securities in Chicago. ``Increasing inflation expectations can actually lead to higher inflation.''

Expectations that gasoline will one day soon cost $2.50 a gallon may cause people to hoard gasoline at last week's average price of $1.56. A rush on gasoline pumps might make the fear of higher prices a self-fulfilling prophecy, as stations boost what they charge to profit from the extra demand.

The Fed has been increasing calling attention to consumer expectations about prices -- both to explain why inflation has been relatively benign through most of the expansion that began in April 1991, and why it could become an intractable problem as it was in the 1970s and 1980s.

Greenspan Warning

Fed Chairman Alan Greenspan told Congress in July that rising energy prices by themselves couldn't lead to a broad pickup in inflation. ``The key to whether such a process could get under way is inflation expectations,'' he warned. ``Any deterioration in such expectations would pose a risk to the economic outlook.''

Central bankers repeated his warning Oct. 3 in announcing they were holding the overnight bank lending rate at 6.5 percent. And they cautioned that ``the subdued behavior of those expectations so far has contributed importantly to maintaining an environment conducive to maximum sustainable growth.''

It's not much different from a bank panic, say economists. Yet unlike runs on banks, which can be halted by supplying cash to satisfy all the demands of depositors, inflation panics are difficult to undo. Once consumers and business expect prices to rise, they don't resist inflation.

Once embedded in the economy, inflation can become a drag on consumer confidence, making it difficult for consumers to plan and giving them little incentive to save.

`Insidious Disease'

``Inflation is regarded by most people as an insidious disease,'' said Robert Shiller, a Yale University professor who has studied the psychology of inflation. ``One thing that's characteristic of the times we're living in is that confidence is high and one reason is because people think inflation has been solved.''

The problem for the Fed is that inflation expectations are tough to measure. Investors place their bets on where inflation is going every minute of every day in the form of bond yields. Households are not nearly so precise.

However imprecise the measurements, the evidence so far is that consumers aren't letting higher energy costs sully their view on the economy's future.

The Federal Reserve Bank of Cleveland, which commissions a survey of Ohio households, says inflation expectations have been stable for months, even with crude oil prices up 56 percent in a year's time.

3 Percent Expected

The University of Michigan's survey of consumers, which also measures inflation expectations, shows that consumers expect inflation to rise 3 percent a year over the next five to 10 years.

That figure is based on the median response of a monthly survey and has stayed at roughly that level for four years -- during a period when inflation measured by the Labor Department's consumer price index rose at about 2.3 percent a year.

The survey estimate is also a bit below the 3.4 percent annualized inflation rate of the first eight months of this year. Still, it's well down from the 4.6 percent inflation rate they survey showed consumers feared a decade ago.

``That gives the Fed reason to cheer,'' said Richard Curtin, who runs the Michigan survey. ``If long-term expectations were going up, they'd be building these expectations into their wage demands.''

Still, the surveys are far from definitive. The Cleveland Fed survey, for example, shows that women frequently overstate the real rate of inflation by as much as 2 percentage points. That error is true for all socioeconomic groups, said Fed researcher Michael Bryan.

Even with this error, Bryan says, consumers are much better than economists at noticing when inflation changes course.

`Consumers Are Flexible'

``Consumers are more flexible than economists,'' said Bryan. ``When the models fail, all of the economists are going off in the same direction together.'' Throughout the 1970s, consumers were better than economic forecasters at predicting inflation; forecasters have since caught up, say researchers.

One reason consumers seem smarter is that they're regular price-checkers. ``They buy gas, buy their lunch -- they get information,'' said Michigan's Curtin. Consumers can see for themselves that prices aren't spiraling higher by simply driving down the street and looking at what service stations are charging, Curtin said.

That's not to say consumers aren't worried. A 19 percent rise in retail gas prices has hit American wallets in a variety of ways.

``I have to budget differently,'' said Tina Johnson, a 26- year-old police dispatcher in Chicago who was paying $1.69 for a gallon of unleaded fuel on the city's West Side. ``Going out to eat and stuff, I can't do that like I used to.''

Yet the Fed's chief concern -- that consumers will try to recoup those higher gas prices by asking more in salary -- doesn't seem to be bearing out. Will she ask her bosses for a raise? ``They wouldn't listen,'' said Johnson, laughing. ``We're already in a pay dispute with them.''

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-- Carl Jenkins (Somewherepress@aol.com), October 11, 2000