The Role of Inflation and Inflation Expectations in the Current Dismal Recovery

A number of different economic and political conditions have contributed to the sluggish rate of the current economic recovery; some of these, such as substantial defense cuts, are widely recognized whereas others are poorly understood. This latter category includes the role of inflation and inflation expectations, and especially the gap between the two. The long-term bond market seems to be pricing bonds under the assumption of average inflation over the long run of about 4 percent, but most producers (both firms and employed individuals) see substantially less inflation in their immediate futures. Some observers have put this same observation somewhat differently by arguing that real interest rates are relatively high and that the Fed should drive down nominal interest rates to get the recovery moving. I think that is a misleading way to analyze the policy significance of the current state of inflation expectations. The question is whether policy should bring actual inflation up to the level of inflation expectations, or inflation expectations down to actual inflation.