Federal Reserve Bank of St Louis President James Bullard said on Saturday that an explicit inflation target would help policy-makers prevent either deflation or inflation from taking hold in the United States.

"An inflation target would help focus expectations," he told a panel discussion during the annual meeting of the American Economic Association.

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"Maybe now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation. ... I think it would help," said Bullard

At a time of great concern about financial turmoil, we should keep in mind that instability in the general level of prices — whether inflation or deflation — is itself a significant source of financial instability. Federal Reserve officials, myself included, have spoken of the importance of keeping inflation expectations well anchored. When the public's inflation expectations begin to rise, that can contribute to higher actual inflation...

It is just as important that inflation expectations remain well anchored in the face of falling energy prices. Significant declines in gasoline and fuel oil prices, for instance, have recently led to declines in the consumer price index. This has prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat. Although the recent dramatic declines in energy prices have led to declines in the monthly headline CPI, it still increased 3.7 percent over the last 12 months while core CPI increased 2.3 percent. So we are not close to a sustained deflation. The recent declines are simply the mirror image of the increases we saw earlier in the year. As long as inflation expectations remain well anchored, these declines in energy prices are unlikely to lead to sustained deflation any more than their previous increases were likely to lead to sustained inflation.

To help anchor expectations, the Fed must credibly commit to preventing sustained deflation from becoming widely anticipated, just as it must prevent sustained inflation from becoming widely anticipated. I have long argued that monetary policy would benefit from establishing a clear and explicit inflation target as a way of signaling a commitment to keep inflation low and stable. Such an inflation target would be just as valuable in preventing expectations of deflation from materializing.

Some fear inflation expectations are on the move in reaction to recent experience. As suggested a moment ago, I don't hold that view. But I feel that it's important to acknowledge that not enough is known about transitional periods from one state of expectations to another. Even though we're measuring expectations, there's an element of looking back to gauge their essence. I do not dismiss the view that we run the risk that by the time change in expectations is clear, it's too late. In my view, we need to know more about how and why inflation expectations shift.

That said, years of hard work by economists have gone into developing the measures of inflation expectations we currently track. And I have challenged our Atlanta Fed research staff to build on this progress.

Some have taken comfort in the fact that inflation has not yet been built into wage growth as evidence that inflationary expectations have not risen. But I am less sanguine because research indicates that by the time we have statistical confirmation that wages are increasing at rates higher than the rate of growth of productivity, a persistent rise in inflation most likely would already be in train.

I want to make clear that the rise in inflation expectations in the 1970s was not caused by a wage-price spiral. That story has things backwards. The wage-price spiral was a consequence of the inflation and the unanchoring of expectations of inflation, not the other way around. And the unanchoring of inflation expectations was caused by the public’s loss of confidence in the Federal Reserve’s resolve to bring inflation back down. The credibility of the Fed’s promise to deliver price stability was lost.
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I want to emphasize that what we have been seeing in the economy this past year, and in my own outlook going forward, is very different from the 1970s, because I see the Fed as committed to keeping inflation expectations well-anchored. I agree with a statement Fed Chairman Bernanke made in June that the Fed will strongly resist an erosion of longer-term inflation expectations, because an “unanchoring” of those expectations would be destabilizing for economic growth as well as inflation.

The currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation.  If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term.  A critical responsibility of monetary policy makers is to prevent that process from taking hold.
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In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

We're approaching a crossroads. The FOMC responded to the difficult economic conditions that emerged last year by easing monetary policy substantially. ... I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided. Of course, the underlying housing, credit, and commodity-price issues are far from fully resolved. My discussion of those issues makes clear that a lot of uncertainty surrounds my outlook. A lot could still go wrong.

But maximum sustainable employment is only one of our mandates. The other is low and stable inflation. In the wake of rapid increases in prices for gasoline and food, consumer survey measures of longer term inflation expectations have turned up. In contrast, other surveys, such as the Survey of Professional Forecasters, show little erosion in long-term inflation expectations. In addition, the anecdotes I hear are more consistent with credibility than with an upward wage-price spiral. In particular, my contacts uniformly report that they see no signs of general wage pressures.

On balance, I still see inflation expectations as reasonably well anchored and I anticipate that consumer survey measures will come down once oil and food prices stop rising. But the risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop.

As I began with a reference to Shakespeare, let me end with one as well: For monetary policymakers, "readiness is all." By this I mean that, in the face of these competing risks, we will monitor developments carefully and be prepared to act as needed to fulfill our mandate for sustainable economic growth and price stability.

U.S. inflation has risen recently, largely because of these sharp increases in global commodity prices. However, thus far, the high costs of energy and other primary commodities have not led to much increase in core inflation, partly because of slackening domestic demand, and there is little evidence that these costs are feeding a wage-price spiral. Nevertheless, the latest spike up in energy and food prices has raised the upside risk to inflation and inflation expectations, which we are closely monitoring and seeking to contain.

Competitive trading markets are impressively effective mechanisms for weighing and amalgamating widely divergent views, and so one shouldn't ignore the information embodied in market prices, and I don't. The implied forecast misses have been predominantly on the high side in recent years, however. The risk for inflation dynamics is that elevated rates of increase in overall price level become embedded in expectations.

My sense is that actual headline inflation in excess of 3.0 percent coupled with inflation expectations near 2.5 percent will not be compatible for long. If inflation remains elevated, inflation expectations will begin to move higher. Market participants, businesses, and consumers will come to view higher inflation as part of the economic landscape, in part because of doubts about the Fed’s ability and willingness to keep inflation contained. These expectations, if allowed to persist, will then feed into the equilibrium of the economy and will be difficult to reverse. In short, credibility is much easier to keep than it is to recover.

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors.  First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks.  But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.

The second category of questions involves the channels through which inflation expectations affect actual inflation.  Is the primary linkage from inflation expectations to wage bargains, or are other channels important?  One somewhat puzzling finding comes from a survey of business pricing decisions conducted by Blinder, Canetti, Lebow, and Rudd, in which only a small share of respondents claimed that expected aggregate inflation affected their pricing at all.¹¹  How do we reconcile this result with our strong presumption that expectations are of central importance for explaining inflation?  Perhaps expectations affect actual inflation through some channel that is relatively indirect.  The growing literature on disaggregated price setting may be able to shed some light on this question.¹²

From the perspective of monetary policy, just as important as the behavior of actual inflation is what households and businesses expect to happen to inflation in the future, particularly over the longer term.  If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly. Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve.  We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations. In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored--whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought--then I believe that we would be facing a more serious situation.

The Federal Open Market Committee will be monitoring inflation developments closely for any sign that our longer-run objective of promoting price stability is threatened.

I think there is a real danger and the psychology around inflation is beginning to change. Expectations about inflation are beginning to change and that is a major concern to me.

Once people start passing this on, start thinking about inflation as a way of life, behaviors change

As reported by Market News International and Reuters