Inflation remains one of the big items on the policy agenda with the IMF’s latest World Economic Outlook devoting a considerable amount of space to the topic, warning that “central banks should remain vigilant about the possible inflationary effects of recent monetary expansions.” In fairness the IMF does use the stock phrase beloved of policy analysts that “long-term inflation expectations have stayed relatively anchored.” However this comes at a time when parts of the macroeconomics profession are beginning to question just how much we really know about the inflation generation process, with the role of expectations coming under particular scrutiny.
Like many areas of economics the forces underpinning inflation have been subject to various fads over the years. Between the 1950s and 1970s, attention focused on the labour market and the role of the wage bargaining process. During the 1980s monetary trends were the flavour of the period but over the last 25 years the main area of focus has been the deviation of output from the NAIRU and the determination of inflationary expectations. Given the change in fashions over the years, it is difficult to take seriously the idea that there is a generic theory of inflation: like theories of the exchange rate, different factors drive the process at different times.
For my part, I have long harboured doubts about the way macroeconomics treats inflation (see the posts Do we know what drives inflation? from August 2017 and Monetary policy complications from October 2017 for more detail). It was thus heartening to see that economists at the Federal Reserve share similar reservations. In a highly readable paper published last month, which received considerable media exposure, Jeremy Rudd of the Fed staff posed the question ‘Why do we think that inflation expectations matter for inflation? (and should we?)’
As the paper’s abstract noted, “A review of the relevant theoretical and empirical literature suggests that this belief [in expectations] rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” Rudd goes on to describe competing models of inflation used by macroeconomists over the past 50 years and concludes that the use of expectations to explain inflation dynamics is both unnecessary and unsound. In his view it is unnecessary because it can be explained more readily by other factors and unsound because it is not based on any good theoretical and empirical evidence. Moreover, the theoretical models are influenced by short-term (usually one period ahead) expectations, which “sits uneasily with the observation that in policy circles … much more attention is paid to long-run inflation expectations.”
The empirical evidence suggests little evidence of a direct effect of expectations on inflation. According to Blinder et all (1998)[1], “what little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a pre-emptive fashion.” Evidence from the Atlanta Fed survey of business inflation expectations over the past decade confirms that expectations have been remarkably constant until relatively recently with unit costs one year ahead generally expected to grow at an average rate of 2% (chart). However, it is notable that during 2021 there has been a sharp pickup as the economy suffered bottlenecks in the wake of the pandemic.
The standard central bank view of inflation expectations was highlighted in a 2019 speech by BoE MPC member Silvana Tenreyro. It is a perfectly fine piece of conventional economic analysis as befits an orthodox central bank economist. She noted that household inflation expectations are a key input into the BoE’s thinking, arguing that for any given interest rate, higher inflation expectations increase households’ incentive to spend today rather than saving. But once you start digging below the surface, the argument rests on some weak foundations. For example, the evidence from both the US and UK suggests that households consistently expect CPI inflation to average close to 3% at horizons of between one and five years ahead. In other words, despite the best efforts of central banks, households continue to expect inflation to run above their target rate. Tenreyro was also forced to concede that “households do not always adjust their expectations even when prices start rising more quickly or slowly than they had expected” which really ought to raise some questions about their usefulness.
A more serious criticism of inflation expectations came from Rudd who pointed out that “the presence of expected inflation in these models provides essentially the only justification for the widespread view that expectations actually do influence inflation … And this apotheosis has occurred with minimal direct evidence, next-to-no examination of alternatives that might do a similar job fitting the available facts, and zero introspection as to whether it makes sense.” Instead Rudd offers the explanation that the absence of a wage-price spiral is one of the key defining features of recent inflation dynamics. He goes on to suggest that “in situations where inflation is relatively low on average, it also seems likely that there will be less of a concern on workers’ part about changes in the cost of living … But this is a story about outcomes, not expectations.” In other words, when inflation is below a certain threshold level workers stop pushing for bigger wage hikes which has contributed to keeping inflation low – unlike in the 1970s.
This has a number of important policy implications:
- First, it will be important to keep an eye on whether wage settlements are responding to higher price inflation.
- Second, because central bank economists, who are influenced by latest academic thinking, generally tell policymakers that “expected inflation is the ultimate determinant of inflation’s long-run trend, [they] implicitly provide too much assurance that this claim is settled fact. Advice along these lines also naturally biases policymakers toward being overly concerned with expectations management, or toward concluding that survey- or market-based measures of expected inflation provide useful and reliable policy.”
- Third, precisely because inflation dynamics are influenced more by outcomes than expectations, “it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “reanchor” expected inflation.”
- Finally, “using inflation expectations as a
policy instrument or intermediate target has the result of adding a new
unobservable to the mix. And … policies that rely too heavily on unobservables
can often end in tears.”
Even if you do not accept Rudd’s premise (and many mainstream economists do not) this is an important contribution to the debate. One of the criticisms being bandied around as the economy rebounds from the 2020 collapse is that there is insufficient diversity of thinking around some of the key underpinnings of mainstream macro. If nothing else, Rudd forces us to think more critically about how we think of inflation and our understanding will be all the stronger for it.
[1] Blinder, A., E. Canetti, D. Lebow, and J. Rudd (1998). ‘Asking About Prices: A New Approach to Understanding Price Stickiness’. New York: Russell Sage Foundation.
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