Inflation as a State of Mind

By Nell Henderson
Washington Post Staff Writer
Wednesday, July 11, 2007

The steep rise in oil prices in recent years has not triggered either high inflation or a recession, in large part because consumers and businesses expect price increases to remain tame, Federal Reserve Chairman Ben S. Bernanke said yesterday.

That contrasts sharply with the experience of the 1970s, when spiking oil prices combined with expectations of high inflation to fuel double-digit price increases and slower economic growth, he said in a speech to economists at the National Bureau of Economic Research Summer Institute in Cambridge, Mass.

The Fed chairman made no mention of the central bank's interest rate policy or its forecast for inflation or economic growth in coming months. He is scheduled to testify to Congress on those subjects next week.

Light sweet crude oil closed yesterday at $72.81 per barrel, up 62 cents, on the New York Mercantile Exchange, the latest stop in a choppy climb since 1998, when it was trading for less than $15 a barrel.

Yet consumer prices rose 2.7 percent in the 12 months ended in May, the Labor Department said. That is higher than the Fed would like but far less than the 13.5 percent inflation in 1980, after the 1979 Iranian revolution sent oil prices soaring.

Bernanke attributed this difference in part to the Fed's progress in reducing inflation since the early 1980s, which in turn has caused consumers and businesses to lower their expectations of inflation.

Fed officials believe it is critical to hold down inflation expectations because of the danger that they can be self-fulfilling: If consumers expect prices to rise, they may more readily pay higher prices; if businesses expect inflation to pick up, they may be quicker to raise prices to cover costs.

"Undoubtedly, the state of inflation expectations greatly influences actual inflation, and thus the central bank's ability to achieve price stability," Bernanke said.

Ideally, if inflation expectations are very stable, or "anchored," they won't vary with swinging oil prices, economic booms or busts, employment data or other changing aspects of a dynamic economy. Bernanke said expectations are better anchored than in the past, but not completely, because they still respond to economic news.

"Long-run inflation expectations do vary over time," Bernanke said. "They are not perfectly anchored."

Stock prices, which were already down yesterday because of poor corporate earnings and rising oil prices, slid to their lowest point in nearly three weeks, after Bernanke's cautionary remarks.

The challenge for Fed policymakers is to figure out how best to monitor inflation expectations, to better understand how they are determined and to learn more about how they influence businesses' price-setting decisions, Bernanke said.

"Our ability to forecast inflation and predict how inflation will respond to policy actions depends very much on our capacity to measure and to understand what determines the public's expectations of inflation," he said.

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