Thursday, July 3, 2008

The Importance of Inflation Expectations

During the 1960s and 1970s, Milton Friedman helped change attitudes to Monetary policy and inflation with his theory of adaptive expectations. This model suggested that expectations of inflation played a crucial role in determining future inflation. A simple application states inflation expectations = last years inflation rate.

However, a limitation of the model was that it assumed that people's expectations were always based on the past, leaving no room for future trends. In practice, people's expectations of inflation is far more complex than simply looking at the past. This led to the development of rational expectations, which stated people would rationally be able to predict future inflation based on numerous variables.
  • For example, if consumers saw an excessive loosening of monetary policy, they would know that this would not increase real GDP, but just cause inflationary pressure to build; therefore, inflationary expectations would change immediately and not wait for the inflation to occur.
Of course, this rational expectation model places great faith in the economic reasoning of the average consumer. If my economic students don't grasp the inflationary impact of expansionary monetary policy, I'm not sure we can expect Tom, Dick and Harry on the street to correctly forecast inflation on the grounds of excessive growth in the money supply.

Nevertheless, inflation expectations are very important and in the long term the attitude and success of the Central Bank is important for influencing inflation expectations.

What Determines Inflation Expectations?

Current Inflation. This is undoubtedly important. Higher inflation does feed through into higher expectations. The several years of low inflation has helped to reduce inflation expectations; there is a danger that the current oil induced inflation spike could feed through into higher expectations and this could damage the good work done in the past decade.

Perceived Inflation. The problem is that consumers increasingly don't trust inflation statistics. For example, many in the UK, feel that their personal inflation rate is significantly higher than the official CPI index. We looked at reasons why this might be the case - see: Real inflation rate.

Cost Push or Demand Pull inflation. It is interesting that consumers inflationary expectations seem to be largely based on the price of important commodities. They place less emphasis on the economic cycle. Central bankers are hoping that the forthcoming slowdown in economic growth will reduce inflation expectations, but, it is not clear whether consumers make the link between slowing growth and lower inflation. I often notice people assume inflation and recessions go together.

Difference Between Nominal Bond Yields and Index Bond Yields. One gauge of measuring inflation is the difference between the yield on index linked bonds and ordinary nominal bonds. The theory is that if people expect inflation to rise, they will need a higher yield on nominal bonds to compensate for the threat of inflation. However, there are limitations of this method, as the market for index linked bonds is relatively small and other factors can affect bond yields as well as inflation expectations.

How Inflation Expectations Influence Inflation and Monetary Policy

If people expect low inflation, monetary policy is more effective. A quarter point rise may be sufficient to reduce inflation. If people have high inflationary expectations, the Central Bank may need to increase interest rates by a much bigger % to have a similar effect.

For example, in 1990, interest rates in the UK needed to rise to 12% to reduce the inflation of the Lawson boom. In the US, interest rates were 10%, when inflation was only 4%.

Central banks definitely have much benefit from keeping inflationary expectations low. The only problem is that reducing inflation with rising oil prices, could push the economy into recession; it is certainly a difficult dilemma.

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My Vision said...

Found you on Bloggers Idol. Good luck to you.
Have you read the book Your money or your life? It talks about how you only incur inflation on certain things while other things actually deflate over time (technology like computers and televisions and phones, etc), so when predicting for your own personal future inflation is overrated. I'm curious what your thoughts are on this.

Tejvan Pettinger said...

Unknown said...

Oh! This is how it all works. When I was told about Cost Inflation Index, I was confused but glad I came across this informative post. I am going to share this with all my friends because sooner or later every one of us will investing one or the other thing.