In today’s story, we revisit some high school economics, and see why one economist believes we may have got inflation all wrong

The Story

This story starts and ends with inflation.

When you pay more for your ice cream this year compared to the same time last year, you’re probably looking at inflation. This could happen because cocoa beans are now more expensive. The price of dairy may have jumped because there’s not enough cattle feed going around. Or maybe transporting ice creams across the country costs a pretty rupee thanks to higher fuel and wage costs.

As you can see, there are a lot of variables that contribute to inflation. But there’s something else that affects price rise and here’s what mainstream economic theory has to say about that.

Let’s say that you believe ice cream prices are going to be higher in the future. And other people believe it too. Well, that belief could actually impact prices today and aid inflation. That’s right, your ‘expectations’ matter. And your fear of future inflation could be self-fulfilling.

How?

Well, what do you do if you fear higher prices in the future? You seek higher wages because you want to get ahead of this problem. And that creates wage inflation. Now, businesses can pay you higher wages. But, that also means they’ll increase the prices of things they produce. Things like ice cream.

When you see ice cream prices actually rising, you’ll believe that future prices could be even higher. And the cycle continues. It’s a self-fulfilling prophecy to a certain degree and it’s not a fringe idea either.

For instance, central bankers routinely harp about the need for ‘anchoring inflation expectations.’ Meaning they want to use every single tool at their disposal to temper expectations so that inflation isn’t a problem in the future.

But then, this chap, Jeremy Rudd — a senior advisor at the US Federal Reserve (US Central Bank) comes along and suggests that this may all be bunkum.

For the uninitiated, The Fed as its commonly known is easily one of the most powerful central banks in the world. The decisions they commit can have ripple effects across the globe. As it stands prices are slowly rising, in the US and across the globe. But central bankers haven’t intervened in any meaningful sense, because they believe inflation will just go away. And they want other people to believe it too.

But earlier this week, Rudd published a paper saying that this thing about ‘inflation expectations’ isn’t founded on real evidence. That “adhering to it uncritically could easily lead to serious policy errors.”

Why? What did he find out you ask?

Well, there isn’t so much fact-finding in the paper if that’s what you were expecting. Instead, as we already noted, there is a critical examination of the evidence supporting the “expected inflation hypothesis.” He believes that this idea is so ingrained in mainstream economics that it’s now a supposed feature of reality that “everyone knows” is there. But when you look at the evidence, you’ll see that inflation expectations have been consistently higher than observed inflation for a while now. Meaning prices aren’t growing as fast as people, businesses and central bankers expect in the U.S. And we may need to critically analyze how we use this hypothesis to calibrate our policy decisions.

In fact, Rudd’s  primary contention throughout the paper is that economists often rely on intuitive ideas like “inflation expectation” to explain the world as we see it, when the truth may be deeply counterintuitive or extremely complicated. There’s even a quote in the paper from F.M. Fisher that succinctly summarizes this view.

“Don’t interfere with fairy tales if you want to live happily ever after.”

So yeah, while this paper is unlikely to suddenly change how central banks go about their business, it may get some more people to think about the utility of inflation expectations.

Until then…

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