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Monday, September 27, 2021

Rudd Inflation Expectations Article

Jeremy B. Rudd caught a fair amount of attention with his recent discussion paper “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)” The text has a lot of zingers that post-Keynesians would write, but Rudd is in fact a researcher with the Federal Reserve.

The paper is an interesting survey of how “inflation expectations” worked their way into neoclassical economic dogma. I am somewhat familiar with the history, but I never really wanted to put on my hip waders and do a full survey. From what I can tell, the Rudd article offers a very good starting point. (I am writing an inflation primer, but I am shying away from any disputed theory. The material in the Rudd article would make its way into a projected follow up article that digs into the theory.)

The strength of the Rudd article is its survey of empirical work on inflation expectations (many of which featured Rudd as an author). I am not familiar with most of the cited empirical papers (if I read them, it was a long time ago), and so I cannot offer any definitive comments. However, my bias is to agree with the premise that the empirical basis for neoclassical beliefs about inflation expectations is somewhat shaky.

Rudd also offers some views on the implications of his survey. One comment caught my eye:

Related to this last point, an important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “re- anchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is high relative to recent experience in order to effect an increase in trend inflation would seem to run the risk of being both dangerous and counterproductive inasmuch as it might increase the probability that people would start to pay more attention to inflation and—if successful—would lead to a period where trend inflation once again began to respond to changes in economic conditions.

The premise is straightforward: inflation has behaved differently in the developed countries in the 1990s than the 1970s because most people largely stopped paying attention to it (other than the general elevated concern about gasoline prices, and of course the hard money enthusiasts have been panicked about imminent hyperinflation for decades). This is not the same thing “anchored expectations” as neoclassicals view it — inflation expectations were still exceedingly important, they just didn’t move.

This view about inflation implies that theories that rely on the central bank guiding economic trajectories exactly via expectations management — such as nominal GDP level targeting — are misguided. Expectations management would do diddly squat if nobody cares about inflation, and then if inflation psychology did take off, it not be possible to quickly get everything back on target.

That said, the issue remains: will economic behaviour actually change, even if people are worried about inflation? If firms unilaterally set their total wage spending target, only moving because of “market conditions” (e.g., shortages), it does not really matter what the workers think about inflation. For the neoclassical story to be true, workers would need to quit their jobs because the cost of living rose. Good luck finding a statistically significant sample of such workers in the post-1990s era.


For me, the interesting part of expectations is how neoclassical model content is largely swept under the carpet. The reason for this is that if we looked critically at the models, they raise a lot of questions.

The first thing to note is that benchmark neoclassical models assume general equilibrium: there is a set of prices that causes all agents in the economy to achieve optimal outcomes.

That is, prices magically appear that cause the economy to reach an optimal outcome every time period. This is an assumption, not a prediction of the model. The question is: is this assumption justifiable? Since it is the core of the model, this is just a test of the validity of the model.

One might think that there would be price changes associated with recession events, which has not really been the case (beyond oil price spikes lining up with U.S. recessions). Instead, the argument is that other factors are changing, so the price change does not “cause” the recession.

Although this is problematic, it gets worse when we get to “expectations.” Within these models, the “price vector” is not just current prices: they are projected out to infinity. “Inflation expectations” are really just the change between the time t and time t+1 solution entries.

Does this price vector have any relationship to the real world?

  • The model agents are allegedly able to transact at forward times. Can you buy your “consumption basket” five years forward?

  • If the mathematical “expectations” operator only refers to a belief (a forecast), and not that forward purchases of the aggregate good can take place, by what mechanism can “forecasts” come into “equilibrium?” If we are to believe the models, the equilibrium comes from the meeting of supply and demand curves. There is no mechanism for “market clearing” of people’s feelings about the future.

  • Even if we put aside the concern about the definition of expectations, we see that the price vector is a core assumption of the model. We cannot say that the model says anything about “inflation expectations,” rather that the entire model is built around “inflation expectations” driving all observed economic activity. We cannot make tests of the usefulness of “inflation expectations,” instead, we need to ask: does the model offer any useful information about the economy?

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(c) Brian Romanchuk 2021

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