74 Finance & economics The Economist October 9th 2021
Gratedexpectations
F
or economicswriting—a genre that stylistically is often closer
to computer manuals than to literature—a discussion paper re
cently posted on the Federal Reserve’s website is a blessed relief.
Jeremy Rudd, a Fed researcher, includes quotations from William
Butler Yeats and Dashiell Hammett. He uses such phrases as “ill
tempered pettifogging” and “arrant nonsense”. And, as if channel
ling David Foster Wallace, he has fun in his footnotes, notably one
in which he casually observes that mainstream economics may
serve as “an apologetics for a criminally oppressive, unsustain
able and unjust social order”. Little wonder his paper has become,
by centralbank standards, a socialmedia sensation.
But it is the substance, not the style, of Mr Rudd’s paper that is
most provocative. He directs his arguments at an axiomatic idea in
economics: that expectations determine inflation. The conven
tional story is straightforward. When workers expect prices to rise,
they demand higher wages. When firms expect costs to rise, they
set higher prices. In both cases, inflation becomes a selffulfilling
prophecy. Central bankers’ task is to pin down expectations at a
low, stable level. If they succeed, they can control inflation.
This idea also appears to have been remarkably successful. For
the past three decades inflation in the rich world has been quies
cent. Whenever it has shot above target, it has, soon enough, fall
en back. Expectations are, in the parlance, wellanchored. Indeed,
this is why many economists are sanguine about the current bout
of inflation: supply disruptions will eventually pass, and price
pressures will ease. It is a comforting thought.
Enter Mr Rudd, the author of more than a dozen papers on in
flation over the past two decades. The idea of inflation expecta
tions “rests on extremely shaky foundations”, he writes. First, he
says, the theory is flawed. Models of inflation mostly include ex
pectations as a shortterm variable (that is, what prices will be in
the next month or two). Insofar as expectations matter, though,
central bankers and analysts think of them as a longerterm force,
an underlying trend impervious to cyclical ups and downs. Em
pirically, however, this is hard to document. And whose expecta
tions matter? There are ordinary people, businesses, forecasters
and investors. None, he argues, is much good at predicting prices.
Nevertheless, it is true that the past three decades have seenbothsubdued inflation and low expectations, however measured.
But Mr Rudd’s contention is that the causality has been misdrawn.
It is not that low expectations led to low inflation, but rather that
low observed inflation led to low expectations. As he notes, it was
only after a recession in the early 1990s, when inflation fell sharply
and then stayed low, that expectations were ratcheted down. Mr
Rudd concludes that obsessing over inflation expectations is use
less and dangerous. Useless, because it is observed prices that
count. Dangerous, because central bankers might grow unjustifi
ably confident in their powers of mind control.
The reaction to Mr Rudd’s provocation has been fierce. Tyler
Cowen, a prolific economist at George Mason University, points to
the extreme example of hyperinflation as proof that expectations
matter. When people think their currency will be worth much less
tomorrow, they switch out of it. Ricardo Reis of the London School
of Economics, who has studied inflation as deeply as Mr Rudd,
notes that no variable—neither expectations nor money supply,
unemployment or interest rates—is perfect in predicting infla
tion. Yet each contributes to the picture. Moreover, he adds, there
is plenty of evidence about expectations. Studies show, for exam
ple, that firms that think costs will rise tend to set higher prices.
For all the heat in the debate, there may be some common
ground. Adam Posen of the Peterson Institute for International
Economics, a thinktank, makes a sensible distinction. Over the
long term, inflation expectations and, specifically, whether peo
ple believe the central bank will quell soaring prices, are impor
tant. Mr Rudd implicitly concedes this, writing that it is best for
inflation to “be off of people’s radar screens”. Put differently, it is
good to expect that inflation is and will be a nonissue.
Yet “that is different from saying that fine differences in infla
tion expectations are either wellmeasured or policyrelevant over
shorter time horizons,” says Mr Posen. There is little evidence that
communication alone by central banks can control inflation,
without policy measures. And their credibility stems more from
responses to crises than from attempts to manage expectations.
Janet Yellen drew a similar distinction when she was chair of
the Fed. Stable longterm inflation expectations appear to be
linked to stable longterm inflation, she said in a speech in 2015, in
line with conventional wisdom. But she then pronounced herself
“somewhat sceptical” that central banks can influence expecta
tions simply by announcing an inflation target. Instead, she said,
expectations may only take hold after a central bank keeps infla
tion near its target, a process that could take years.Inspect the unexpected
Some commentators have concluded from Mr Rudd’s paper that
economics is a mess and no one understands inflation. Yet sifting
through the arguments, there are shared ideas of profound impor
tance. First, centralbank credibility is precious. Second, expecta
tions of inflation are formed by experiences of inflation. And
third, in the long run, such expectations probably matter.
What does that mean for the rising inflationary pressures now
facing much of the world? The hawkish view is that central banks
must rein in prices before it is too late and expectations lose their
anchor. Yet there is also a doveish take. Central banks in the rich
world remain credible. By letting inflation run a little higher now,
they may help reset expectations. After all, before covid19, the big
worry in rich countries was toolow inflation. Or, at least, that was
what some economists and investorshadexpected of the future—
whatever their expectations are worth.nFree exchange
A pugnacious paper takes aim at a basic belief about how inflation works