The Expected Inflation Imp

by
Robert Waldmann
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I think the imp is my most noticed contribution to the economic discussion. Brad DeLong mentioned the fact that I mentioned him, but called him the inflation expectations imp . Then Paul Krugman mentioned him shortening the name to “the expectations imp”. Alot of time has passed since then during the slow recovery from the great recession. The Federal Reserve OPen Market Committe (FOMC) cut the Federal Funds Rate to the lower limit of 0 – 0.25% but demand remained low. They could not reach the 2% target, because inflation was persistently below 2%. Many economists argued that it would have been better to target 4% back when they had traction so they could reduce real interest rates to around mins 4% not around minus 2%.

Also fiscal policy was paralyzed by politicians general feeling that deficits were bad (sinful even) and general gridlock.

A lone hope was that the FOMC could manipulate medium term inflation expectations so medium term forecast real interest rates would be very low. I was not convinced that this could work. I must admit (if you click the link Krugman will explain) that arguments about managing mediuim term expectations were made only because there was no alternative and not with any confidence that medium term expectations could be managed.

I joked about the all unexplained market psychology story naming the expected inflation imp by analogy with the confidence fairy mocked by Krugman. There is no doubt that expectations are important — expected demand affects current demand as firms invest if they expect to be able to sell. Expected inflation affects current inflation as firms always plan to keep prices fixed for a while (so as not to enrage customers) and set them so they believe the are optimal compared to the other prices on average until they raise them again. Workers also consider future prices when they consider wages with 3 year contracts.

Again Krugman noted moderate medium term inflation expectations when he correctly guessed that the high inflation of 2021, 2022 and the first half of 2023 would not become embedded and could be reduces without huge costs.

However wishing one could manage expectations is definitely a wish but not a plan. Mometary authorities make anouncements with great care trying to work through the expectations channel. I know of almost no evidence that they succeed. Importantly, at least for the USA< the promises about future actions are promises about what different people will do. There is enough turnover of the FOMC that expectations management requires that other people feel morally bound by promises which they didn’t make and which were made by their predecessors.

Importantly the promise is to let inflation rise above the current target when it is possible for the FOMC to set inflation by setting interest rates which are no longer at the lower bound. Monetary authorities don’t like doing that at all. They also have no precommitment mechanism.

Another problem with communication and the expectations channel is the question of whose expectations (if any) can be influenced. Bond traders pay a huge amount of attention to everything the FED chairman says. But the expectations which matter are those of price setters and wage negotiators and especially home buyers expected future house prices.  Bond traders expectations can be estimated using bond prices. Price and wage setters mainly by surveys. Potential home buyers hardly at all except for veey few surveys limited to particular cities.

I doubt that the imp can be called from the vasty deep, but mostly we just don’t know. It is possible that the recent inflationary episode will end with a soft landing. It is possible that this will happen because inflation expectations were managed brilliantly by Jerome Powell. I am sure I don’t know and I am not holding my breath until I find out.