Wednesday, July 11, 2007

Perception key in setting policy, Bernanke says


WASHINGTON -- If the public thinks inflation will go up, it could be a self-fulfilling prophecy. People could demand bigger raises to pay for more expensive gas, groceries, or rent - and that behaviour, in turn, can make inflation worse.

If, on the other hand, it feels pretty comfortable inflation won't flare up, people might go about their business - for the most part - as they usually do.

Those "inflation expectations," the mind-sets of both the public and investors about where prices are heading, play an important role for Federal Reserve policy makers in their efforts to tame inflation.

"Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability," Fed chairman Ben Bernanke said yesterday in a speech at the conference of the National Bureau of Economic Research, which shed light on the role consumers and investors play in influencing the country's economic well-being.

If investors, consumers and businesses feel confident that the Fed will keep prices stable, Mr. Bernanke suggested, they may be less inclined to act in ways that could aggravate inflation. He also said that people may be less inclined in such circumstances to worry that inflation will eat away at investments and paycheques, and might feel better about long-term financial planning.

"Experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally," he said. And that can hurt "risk-taking, investment and other productive activities.

In his remarks, the Fed chief didn't say anything specific about the future course of rates in the United States. The Fed's key interest rate has held steady at 5.25 per cent for just over a year. Before that, the Fed had pushed rates up for two years to fend off inflation, the longest stretch of increases in the central bank's history.

At the Fed's last meeting, Mr. Bernanke and his central bank colleagues said the biggest risk to the economy was if inflation failed to recede as they anticipated.

Mr. Bernanke's remarks yesterday touched on the challenges of measuring inflation expectations.

"If the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored," he explained.

"If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored, he said.

Although inflation expectations seem much better anchored today than they were a few decades ago, "they appear to remain imperfectly anchored," he observed.

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