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Janet Yellen and the Self-Fulfilling Prophecy

Last Wednesday, March 15th, the Federal Open Market Committee (FOMC) met again to discuss the state of the economy. In their meeting, they decided to push rates up another 25-50 basis points (or .25 - .5%), in line with the guidance they gave back in December (if you don't recall what this all means, take a gander at this piece from the last hike).

Again, this is done in pursuit of managing inflation and ensuring that truth moves at an even pace. But what does managing inflation really mean? Furthermore, is Yellen’s trigger happy view of inflation only serving to drive it higher?

The question centers around Expectations Theory, one of the core ideas in economics.

As you know, inflation is a rise in the prices across a given economy, as measured by a variety of price indices (i.e. the Personal Consumption Expenditures Index). If you're thinking that an increase in prices doesn't sound so good, then you're right... but only sort of. If you think of the economy in its simplest form, you have two players: employees, who get paid and buy stuff, and businesses, which pay wages and sell stuff. If businesses and employees are able to raise their prices/wages and still sell their goods/keep their jobs, then inflation isn't so bad. On the other hand, if they cannot then they lose in the game of inflation.

The issue however is that expectations of inflation tend to be self fulfilling prophecies. The two ways that inflation occurs are demand-pull and cost-push:

Demand-pull inflation occurs when the majority of the economy is at full capacity (which is when Real Potential Gross Domestic Product is equal to Real Gross Domestic Product, or the output gap is zero) and there is an increase in demand for the given market. This excess demand creates a shortage and pulls prices up. Put another way, everyone in our two-player economy is confident that they can get more for their labor/goods, since the economy is doing well (i.e. output gap = 0), or there is an influx of new money into the economy by the Fed (AKA quantitative easing).  This is also categorized by workers having more disposable income from successfully squeezing out more money from employers, since they are confident that they won't be unemployed if they try.

Cost-push inflation occurs when the output gap is greater than zero and a significant portion of the economy (either several small markets or one big market) raises prices without excess demand. This raises prices in exactly the way that it seems: firms raise prices (a cost to consumers) and workers demand higher wages (a cost to businesses) and they are pushing costs upward. However, since there is not an excess demand present, they are not 100% sure that they will actually sell anything, or stay employed, respectively. They key to it is that the firms and employees know that there is a very small possibility that they will be shut out; just think of OPEC and labor unions, they know that if they talk, people will listen. Most economists see this as "bad inflation," as the economy is not at full production and it is merely a cause of a few heavy-handed players.

So now that you know what causes inflation, you might be wondering how I'm going to pin the blame on our dear friend Janet. Let me show you:

As I mentioned earlier, regardless of how inflation occurs, expectations are at the root. If workers are told time and time again that inflation will increase to some target percentage, then they are going to make sure that their wage increase for the coming year is above and beyond that level.

So, for example, if Janet Yellen says that there will be 2% inflation next year and their company gives them a 2% wage increase for the same period, then they will turn around and fight for 3-4% increase (maybe even more). This increase in labor costs to the business will force them to increase the prices that they charge to consumers for their goods, thus either meeting, or out-pacing, the inflation target. This principle also applies to firms, should they increase prices to out-pace inflation expectation that might not even occur.

Just like all the great fortune tellers of the world (The Oracle of Delphi in Oedipus, the witches in Macbeth, etc.), Yellen wants you to believe that the economy will act a certain way and you, trying to take measures to prevent destruction at the hands of the prophecy, will do everything you can to protect yourself from 2% inflation only to actually make it happen.

Feel cheated yet? No? Well, take a look at the chart below and tell me if we are likely experiencing inflation from an excess demand or from a rise in costs. (Hint: it's not an excess of demand).

Output gap

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