Expectations formation, inflation, and a role of inflation targeting

Ever since the Lucas Critique forced economists to recognise that we could not use data for policy in a purely theory free way, the concept of expectations, and how expectations are formed has become important.  The growing interest in behavioural and neuroeconomics are all in part a response to this realisation, and a clearer understanding of these issues will help give economists an idea of what to study, what to measure, and what policy trade0-offs exist.

It is encouraging then to see this study on the formation of inflation expectations.  In it they look at how shocks to food prices impact upon individuals expectations of future general inflation.

Our results suggest that consumers incorporate information about past food prices in forming and updating their own-basket inflation expectations but not their overall inflation expectations. The issue of pass-through to inflation is of particular concern during times of large supply shocks. Our finding that information about past food price inflation has limited pass-through to consumers’ expectations of the “rate of inflation” suggests that the RI question (and not the PP question, which as mentioned above is similar to the one used in the Michigan survey) is a more stable survey question (in the sense that it is less susceptible to volatile price changes), and that it should instead be used to elicit consumer inflation expectations.

This is all well and good, but we need to ask whether we are really gauging inflation here in the way we mean it when we discuss monetary policy.  We are interested in the way prices in general move together that is unrelated to “fundamentals”.  A lift in food prices is a change in those fundamentals, and tells us that there is a change with regards to how scarce food is relative to other goods and services and relative to labour.

This general “comovement” we are talking about is anchored by an inflation target, and as a result we want a description of how a “shock” to the price of one good has an impact on this over the complicated beast that is the economy.  We need to seperate out the bit that is due to households feeling “poorer” or “richer” following a change in the price of one good or service (a relative price, or supply shock) from the impact it has on the general price setting of households and firms (our inflation).

This is easier for us to think about if we assumed the “inflation target” was zero – in that case, as decision makers we know that a rise or drop in prices represents a lift or decline in scarcity relative to other goods and services.  Furthermore, a increase in wages represents productivity – or may represent a change in bargaining power.

However, with an inflation target, which is followed by decision makers, we can say the same thing by just taking off the inflation target from price growth.  This is one of the conceptual reasons why an inflation target is an attractive thing – we are helping to make price signals in the economy a clearer representation of underlying scarcity.

As the gold standard period showed us, inflation/deflation in itself can be very unstable, so an inflation target through inflation expectations can be used to help “co-ordinate” decision makers.

In this sense, it is nice to see expectations formation being discussed here – but I’m not sure the study is truly capturing “inflation” following a relative price shock, and is instead also capturing other factors related to economic fundamentals.

  • http://brennanmcdonald.com/blog/ Brennan McDonald

    The finding of inaccurate perceptions about food prices reminds me of The Alchemy of Finance by George Soros.

    He argues that biases of market participants reinforce themselves and turn into self-reinforcing trends until there is a correction.

    Thus higher food price inflation would lead to higher levels of expected food price inflation before reality intervenes.

    In terms of financial markets, a positive trend leads to positive expectations, which leads to a self-reinforcing trend until the fake boom is revealed and the reversal of fortune begins.

    I’d argue with inflation targeting that households are inadvertently investing in assets that can benefit from inflation – housing as a main example.

    People in the street seem to understand that inflation leads to higher house prices, but miss the lower real money balance thing.

    • http://tvhe.co.nz/ Matt Nolan

      “He argues that biases of market participants reinforce themselves and
      turn into self-reinforcing trends until there is a correction.”

      This is true, and is definitely accepted in terms of practical modeling by economists. It is surprisingly hard to really figure out how much expectations of inflation are “adaptive” and what part is “forward looking”.

      Definitely an interesting and relevant study, I just get sort of excited thinking about “why” economists concern themselves about inflation and “what” it is – hence why I used it to go on a rant :P

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