• Dissaving. For several years now, US consumers have been spending more than they earn. This "dissaving" was made possible by the steady rise in their property net worth (cf. chart below), financed by a rapid increase in borrowing. But that should change soon!
• Turnaround. Americans will presumably have to save more and consume less: Their net worth will hardly increase much, credit standards are being tightened, their debt service is growing, and rising energy prices and healthcare costs are eating into real disposable income.
• Support. We nevertheless expect no major slump in consumer spending but merely a soft landing. The reason for this is the still robust US labor market and the substantial rise in wages and salaries. The downside risks are, however, increasing steadily (pages 3-5).
• Dilemma. Increasing growth risks coupled with mounting inflationary pressure, i.e. stagflationary tendency, are presenting the Fed with a dilemma: Either abandon the inflation bias and lose credibility or retain the inflation bias and risk a more pronounced economic slowdown. We expect the Fed to opt for the latter.

Further topics:

• Weekly Comment: Fed ??“ managing inflation expectations (page 2).
• ECB: More to come ??“ but not yet next week (pages 6-7).
• Eurozone: Domestic inflationary pressure building up (pages 8-9).
• Data outlook: EMU industrial production to be unchanged; rising energy costs to trigger another strong increase in US producer prices (page 10).
• Market outlook: Eurobonds to remain under pressure; Euro stable (page 16).

MANAGING EXPECTATIONS

As expectations about Fed rate cuts have cooled in recent days, moving closer to our forecast of policy rates remaining on hold for the remainder of the year, it might be useful to reflect a bit more about the Fed??™s thinking and communication. A recent speech by Governor Frederic Mishkin (???Inflation Dynamics???, March 23) has generated a lively debate on whether or not the Fed is likely to try to push inflation below 2%. Some Fed officials have offered different views on whether they would be comfortable with inflation close to 2% even if slightly higher, or whether they need to see it in the 1%-2% or 1.5%-2% range. In my view, as I will argue a bit later, the speech was most interesting because it confirms the Fed??™s strong emphasis on inflation expectations, and provides a further clear indication that rate cuts are very unlikely in our baseline scenario.

Mishkin??™s speech starts from the following observations:

• Inflation persistence has declined, in the US as well as in several other countries. In other words, a shock to inflation tends to disappear more quickly and fully than it did in less happy days (late ???60s to early ???80s).
• The Phillips Curve has flattened. As the curve relates the inflation rate to the deviation of unemployment from its natural rate, this implies that a given change in inflation now corresponds to a larger change in unemployment. To be more specific, Mishkin argues that according to recent estimates it is now 40 times more costly to reduce inflation, in terms of unemployment, than it was two decades ago!

Mishkin then argues that these changes in inflation dynamics have probably been driven to a large extent by a change in the process by which inflation expectations are formed. The change in the expectation formation process, in turn, has been driven by changes in the way in which monetary policy is conducted.

Fed officials, Bernanke and Mishkin in particular, have for some time emphasized the role that monetary policy has played in bringing about the ???Great Moderation???, i.e. a secular decline in both inflation volatility and output volatility. The argument goes roughly as follows: Thanks to better estimates of the natural rate of unemployment, a better understanding of the inflation-output trade-off, and a stronger determination to act preemptively to keep inflation under control, central bankers have been able to ???anchor??? inflation expectations, i.e. make the public confident that whenever a shock strikes that might push inflation significantly above or below a certain level, central bankers will react promptly so as to offset the shock. This anchoring of inflation expectations would help explain, for example, why the spikes in oil prices over the last couple of years have not triggered a persistent rise in headline inflation.

Mishkin then reports that most available measures suggest that inflation expectations in the US are solidly anchored at about 2%, and concludes with a sentence that has generated some excitement: ???Looking to the medium term, I am less optimistic about the prospects for core inflation to move much below 2 percent in the absence of a determined effort by monetary policy.??? If you assume that the Fed will in fact want to push core inflation below 2%, this is indeed alarming because, given the flattening of the Phillips Curve, the ???determined effort??? by monetary policy (rate hikes) might have a considerable cost in terms of employment and output.

This is all true, but, I would argue, largely irrelevant in the current context of weaker US economic activity. What I find most relevant is Mishkin??™s warning that ?????¦if the monetary authorities were to become complacent??¦then inflation expectations would surely become unhinged again.??? This is fully in line with the emphasis on inflation expectations that has regularly recurred in recent FOMC statements. Inflation expectations are seen by the Fed as a key driver of inflation. If the employment cost of reducing inflation has become significantly higher, on the one hand the Fed should think carefully before trying to push inflation expectations below their current 2% level. But on the other hand, it should also certainly be wary of the risk that inflation expectations might rise because then the need to reduce them would be far more pressing, and the employment cost unavoidable. No chance of rate cuts, then, as long as inflation remains ???elevated???.