Publish date:

A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense

A Fed white paper confirms my long-held position on inflation expectations. Let's tune into with a comparison of the Fed's research analysis to my stated opinions.
Author:
Inflation Expectations vs Year-Over-Year Inflation Measures Detail 2021-07

Inflation Expectations Do Not Matter

On several previous occasions I presented a strong case why inflation expectations do not matter at all. 

Here's the Fed white paper that agrees with my findings.

Question of the Day

Please consider Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?) by Fed staff member Jeremy B. Rudd, emphasis mine.

The direct evidence for an expected inflation channel was never very strong. Most empirical tests concerned themselves with the proposition that there was no permanent Phillips curve tradeoff, in the sense that the coefficients on lagged inflation in an inflation equation summed to one.

 In addition, most standard tests of the new-Keynesian Phillips curve suffer from such severe potential misspecification issues or such profound weak identification problems as to provide no evidence one way or the other regarding the importance of expectations (much the same statement applies to empirical tests that use survey measures of expected inflation).  

What little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a preemptive fashion.  

It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought. John Kenneth Galbraith (1958).

Few things are harder to put up with than the annoyance of a good example. Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)

Fed Group Think

Fed Chair Jerome Powell is a total believer in inflation expectations. So were previous Fed Chairs Janet Yellen and Ben Bernanke.

It is all part of the groupthink nature of the Fed. 

Well Anchored Nonsense

Please recall my August 31, 2020 post The Fed's Stupidity is Still Well Anchored.

Former Fed chairs Janet Yellen and Ben Bernanke were both big Phillips Curve advocates despite the fact the theory never worked even according to Fed studies.

I commented: "The Phillips Curve isn't dead, it was never alive to begin with."

Inflation, Uncertainty, and Monetary Policy

Also consider this snip from Inflation, Uncertainty, and Monetary Policy by then Fed Chair Janet Yellen on September 26, 2017.

In standard economic models, inflation expectations are an important determinant of actual inflation because, in deciding how much to adjust wages for individual jobs and prices of goods and services at a particular time, firms take into account the rate of overall inflation they expect to prevail in the future.

With that flashback out of the way, let's return to the more folly from Clarida on inflation expectations.

With regard to inflation expectations, there is broad agreement among academics and policymakers that achieving price stability on a sustainable basis requires that inflation expectations be well anchored at the rate of inflation consistent with the price-stability goal. This is especially true in the world that prevails today, with flat Phillips curves in which the primary determinant of actual inflation is expected inflation.

Powell on Anchoring Inflation Expectations

Policymakers and analysts generally believe that, as long as longer-term inflation expectations remain anchored, policy can and should look through temporary swings in inflation. Our monetary policy framework emphasizes that anchoring longer-term expectations at 2 percent is important for both maximum employment and price stability.

We carefully monitor a wide range of indicators of longer-term inflation expectations. These measures today are at levels broadly consistent with our 2 percent objective.  

The above from Powell's August 27, 2021  speech Monetary Policy in the Time of COVID

What a hoot.

Annoyance of a Good Example

Few things are harder to put up with than the annoyance of a good example. Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)

I happen to have one. 

CPI Percentage Weights

CPI percentage weights 2020

CPI Percentage Weight Components 

  • Food and beverage 15.17
  • Shelter 33.32
  • Other Housing 9.07
  • Transportation Excluding Fuel 12.29
  • Motor Fuel 2.88
  • Apparel 2.66
  • Medical Care Commodities 1.58
  • Medical Care Services 7.29
  • Recreation 5.80
  • Education 3.03
  • Communication 3.78
  • Other Goods and Services 3.16
  • Total: 100.01

Inflation Expectations Q&A

Q: If consumers think the price of food will drop, will they stop eating?
Q: If consumers think the price of food will rise, will they eat twice as much or buy more than their freezer or pantry will hold?
Q: If consumers think the price of natural gas will drop, will they stop heating their homes and stop cooking to wait for the event.
Q:If consumers think the price of gas will rise, can they do anything about it other than fill up their tank more frequently?
Q: If consumers think the price of rent will drop, will they hold off renting until that happens?
Q: If consumers think the price of rent will rise, will they rent two apartments to take advantage?
Q: If people need an operation, will they hold off if they think prices might drop next month?
Q: If people need an operation, will they have two operations if they expect the price will go up?
Q: Will people stop paying their monthly phone bill if they believe a better deal might be available next year?

Elastic vs Inelastic Items

I put in italics relatively inelastic items. Housing, medical care, gasoline, food, auto repairs are all inelastic items. The inelastic total is roughly 80%. 

People will buy inelastic items at a steady pace no matter what their inflation expectations might be.

Sure, people might eat out less or buy chicken instead of beef, but so what? Prices at the grocery store or restaurants is not going to change based on consumer beliefs, which cannot be accurately measured in the first place.

On elastic items, consumers may (or may not) act in advance or delay a purchase, but never for long. If someone needs a coat they generally will buy one and they won't buy another even if they expect prices will go up rapidly. 

Expectations do not enter into play except perhaps in the very short term (e.g. people will wait a week for a coat sale but not a year).

There is no sustainable reinforcing action by consumers or consumers' beliefs that would ever lead to escalating prices of coats or anything else. 

Sustainable is the key word. We have seen shortages of things like toilet paper based on beliefs there may be shortages, but consumer-driven fears and actions are never lasting.

Finally, people shop sales, but they also don't hold off buying computers even though the price-performance ratio drops every year. 

There is nearly always a better price-performance next year on most electronic items, especially computers. 

Yet, inflation expectations never stopped stopped people from buying computers, phones, TVs, etc., did they? 

New York Fed Inflation Expectations Survey

RECOMMENDED ARTICLES

Inflation Expectations vs Year-Over-Year Inflation Measures Detail 2021-07A

Annoyance of Another Good Example

Powell places great faith in the inflation expectations models but conveniently ignores an actual New York Fed ongoing study of expectations.

The above chart shows median point projections above 3% with actual inflation below 2% most of the time and below 1% a significant portion of the time.

Consumers for years expected inflation to rise by over 2% when it never happened (as measured by the CPI). 

For discussion, please see Consumer Inflation Expectations Hit a New 8-Year High

Of course, the CPI itself is fatally flawed because it does not include actual housing prices. 

My last report had year-over-year CPI at 8.57%. For discussion, please see Housing Adjusted Real Interest Rates Sink to a Record Low -8.5 Percent.

Requirements Necessary for CPI-Based Inflation Expectations to Matter

  1. Consumer demand must be elastic. 
  2. Consumers must have a rational choice of action that's sustainable and matters.
  3. Businesses must act on consumer expectations rather than supply-demand forces.

The inflation expectations model fails on all three counts!

Notice the key words "CPI-Based". Consumers can and do participate in asset bubble inflation such as housing. But those are not part of the CPI.

Consider gasoline. Even if consumers expect gasoline prices will rise 100% next year, there is no sustainable actionable plan consumers can take. At best they can top off their tank or fill up when half empty.  Even if everyone did, there could be no further impact because there is no other way to stockpile gas. 

Owners' Equivalent Rent (OER) is a massive 24.26% of the CPI. Rent is another 7.86%. That's 32.12% of the entire CPI.

I assure you that people will not rent two houses if they expect prices to go up. Nor will people stop renting if they expect rent will drop in the future. 

Prices will neither rise nor fall just because consumers expect them to. Nor will expectation actions cause a spiral because most consumer demand is not elastic.

Finally, consumer actions are not sustainable. Eventually consumer actions die out and sooner rather than later. For another example: How much toilet paper or food will people store? 

Competition ensures consumer prices will rise based on supply-demand, not alleged expectations. 

It is an amusing but sorry state of affairs that most economists and the entire pack of groupthink policymakers at the Fed believe with passionate intensity in their obviously broken models

Rudd Conclusion

The best lack all conviction, while the worst Are full of passionate intensity. W. B. Yeats, “The Second Coming” (1920).  

Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation.

A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors

Rudd Methodology vs Mish Methodology

It took Rudd 27 pages to say what I did in a few (but I love his excellent quotes!) Our approaches to reach the same conclusion were very different.

  • I asked a few simple questions and made easily understandable observations. The evidence is also on my side as noted by an actual ongoing New York Fed study of expectations.
  • Rudd asked far more complicated questions that require an understanding of the debunked Phillips Curve. He also presented a mathematical case far beyond the capabilities of most to understand.

Historical Perspective on CPI Deflations: How Damaging are They?

Nonsensical beliefs in inflation expectations and the general idea there is economic benefit from inflation itself drives Fed policy.

Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.

For discussion, please consider my March 30, 2015 post: Historical Perspective on CPI Deflations: How Damaging are They?

Concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt.

Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.

Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI ) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period
.

The above paragraphs are from the Bank of International Settlements (BIS). 

Serious Policy Errors!

Returning to expectations: No one on the Fed, nor Rudd, nor anyone else that I have seen, ever correctly analyzed or even considered what factors need to be in place for inflation expectations to matter.

Instead, economists invented new empirical models based on other models such as the Phillips Curve that were themselves fatally flawed.

Fortunately, Rudd came to the correct conclusion anyway: Belief in inflations expectations models "could easily lead to serious policy errors."

Could or Did?

We already have serious policy errors as a result. Major asset bubble provide all the evidence anyone should need.

The Fed is very wrong in at least two major areas: inflation expectations and the overall need for 2% inflation in the first place.

Stupidity Still Well Anchored

Sarcastically speaking, "It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought."

That is quite a bit more polite than my long-ago stated conclusion: 

Unfortunately, the Fed's Stupidity is Still Well Anchored.

Thanks for Tuning In

Like these reports? If so, please Subscribe to MishTalk Email Alerts.

Subscribers get an email alert of each post as they happen. Read the ones you like and you can unsubscribe at any time.

If you have subscribed and do not get email alerts, please check your spam folder.

Mish