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Do Inflation Expectations Matter?
What can price theory provide to the recent debate?
I am often told that people are stupid. Not us, of course. Other people. Sometimes this is done in a subtle way. Behavioral economics does this in a subtle way, pointing out cognitive biases that lead people to make certain choices when better choices are available. Sometimes this is done more explicitly. For example, more than once someone has pointed to all of the recent tools created by the Federal Reserve during the financial crisis and the pandemic and said to me, “you think people understand what the Fed is doing? I know people with Ph.D.s who don’t understand everything they are doing.” I’m not quite sure this statement communicates the intended message, but I digress.
This sort of argument has been brought up recently in regards to a debate about whether inflation expectations matter. The conversation started with Jeremy Rudd's paper, which asked whether inflation expectations matter for determining actual inflation. This slowly morphed into whether the central bank can actually influence inflation expectations and even whether inflation expectations matter at all.
On some level, inflation expectations must matter. After all, inflation is effectively a tax on the currency in your pocket. As a result, one should expect that higher inflation expectations would induce changes in consumption and the financial portfolios of households as people move away from cash and toward other stores of value. To the extent to which these portfolio effects influence the relative prices of both real and financial assets, there might be additional effects on economic activity. In fact, people like Milton Friedman and Anna Schwartz, Karl Brunner and Allan Meltzer, and James Tobin all devoted time to these portfolio rebalancing effects in trying to understand the monetary transmission mechanism or, in English, the way that monetary policy influences economic activity.
However, the question on some people’s minds seemed to be about how statements and policy actions by the Federal Reserve shape inflation expectations. What if people are uninformed? Will the Federal Reserve even be able to shape their expectations?
There are reasons to take this seriously. Carola Binder has done interesting work trying to figure out what the public does and does not know and understand about policy. For example, during the early months of the Covid outbreak, the Federal Reserve was busy making changes to policy. They cut their policy rate by 50 basis points in March 2020. She found that only 38% of the people surveyed knew that the Fed reduced its policy rate just days before. In other work, she found that the announcement of an official inflation target by the Federal Reserve “at best, weakly improved the anchoring of consumers’ expectations.”
This, of course, does not mean that people are stupid. Perhaps they are just uninformed. It can even be rational to be uninformed. But that hook about stupid people at the beginning of the post really got you, didn’t it?
The question is whether being uninformed actually matters for the central bank’s ability to influence economic behavior in a way that accomplishes its policy objectives. This is where price theory comes in.
A central lesson of Hayek’s “The Use of Knowledge in Society” is that prices communicate information and coordinate economic behavior. If a drought reduces the supply of corn, the price of corn will increase. It does not matter whether consumers know anything about the drought. The price of corn is higher and therefore they know to buy less. The degree to which they buy less will depend on their own unique knowledge, circumstances, and preferences. The result is that this process allocates corn to its most high valued use.
But the price of corn could also be used to gain information. If you knew that there was a drought somewhere in the United States, but did not know where, you could look at the prices of various crops. The spike in the price of corn would give you a clue about the location of the drought.
Armen Alchian famously used this approach to do the first event study in economics. He describes this as follows:
The year before the H-bomb was successfully created, we in the economics division at RAND were curious as to what the essential metal was — lithium, beryllium, thorium, or some other… For the last six months of the year prior to the successful test of the bomb, I traced the stock prices of those firms. I used no inside information. Lo and behold! One firm’s stock price rose, as best I can recall, from about $2 or $3 per share in August to about $13 per share in December. It was the Lithium Corp of America. In January I wrote and circulated [a memo]. Two days later I was told to withdraw it.
It is important to note that this information was top secret. Yet, that information found its way into the stock price. For someone like Alchian, who knew what he was looking for, the change in the stock price communicated the information that he was looking for.
This is why some economists ignore what people say they know about policy and instead look at markets to see whether or not policy influences expectations. By observing how markets respond to the actions (or inaction) of policymakers, one can determine whether policy shapes expectations. Economic theory tells us where to look. This is a critical component of Scott Sumner’s thinking about monetary policy, for example.
Furthermore, the extent to which information about policy is reflected in asset prices will be reflected in economic activity. The reason is that even those who are uninformed about policy will still notice the changes in prices and adjust their behavior accordingly. Just like the corn example, they need not know what is causing prices to change, only that the price provides them with a signal of how to behave.
Prices communicate information and coordinate economic activity.
Of course, this leaves aside other issues. For example, in order for a central bank to shape expectations through their words and actions, they have to be credible. They have to follow through on their promises. This poses a problem for testing whether or not a central bank influences a particular variable via expectations because it requires testing a joint hypothesis. The failure to find evidence that the central bank influences expectations could be a sign that the central bank does not have the ability to shape expectations. Alternatively, it could be a sign that the central bank lacks credibility. (Or both!)
Price theory often teaches us that we shouldn’t listen to what people say, we should observe what they do. In macroeconomics, that is a little bit harder to do sometimes. That is probably why people are arguing.