Inflation expectations? They’re not what you expect

UK consumer price inflation was 3.1 per cent in October, down modestly from 3.2 per cent the previous month, but still well above the two per cent target rate set by the Bank of England. It gets worse – the Bank’s own forecast is for inflation to climb above  four per cent by the end of the year, with the possibility of five per cent in early 2022. Unsurprisingly, Governor Andrew Bailey has started hinting that interest rates will soon need to rise, “Monetary policy cannot solve supply-side problems – but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations.” But what is this focus on expectations, and do they really matter? 

It’s common sense that if people expect prices to go up next year, they will rush out to buy stuff now, causing their prophecy of higher prices to become self-fulfilling. However, a paper last month by Jeremy Rudd, a long-serving economist with the US Federal Reserve Board in Washington, casts some doubts on this assumption. The paper’s title is provocative enough – Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?). One of the footnotes is even more so: “I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.” 

The paper is suggestive of a civil war within US monetary circles. Rudd argues that, both theoretically and empirically, “using inflation expectations to explain observed inflation dynamics is unnecessary and unsound” and warns that it could “result in serious policy errors”. Unsurprisingly, he is harsh on the efforts taken by the Federal Reserve to measure inflation expectations. 

Here in the UK, the Bank of England conducts a quarterly survey of inflation expectations. A representative sample of the population is asked about their experience of inflation over the last 12 months and their expectation for the coming year. We can take the median observation from the survey and compare it to actual inflation to tell if inflation expectations are driving inflation over the one-year time horizon. The answer is no, they’re not. The correlation between the public’s expectations for inflation and what subsequently happens is weak. We shouldn’t be surprised by this: forecasting is difficult. What does correlate well with forecast inflation is previous inflation: if inflation has been above (or below) average, people expect inflation next year to be above (or below) average (and usually it isn’t). Behavioural economists know this as anchoring – the tendency when making forecasts not to think too hard about the future, but instead to rely heavily on the recent past. Colloquially, it’s known as driving forward while looking in the rear-view mirror.

If the evidence that expectations drive inflation is thin, what can we rely on? In a previous piece for TheArticle, I have argued that inflation will ensue if the supply of money overwhelms the supply of goods and services in the real economy. Currently, we are seeing a wide range of bottlenecks and price increases. As Brian Griffiths points out in a recent article, “The current global inflation is a classic case of ‘too much money chasing too few goods.’” For a variety of reasons, though, this is unlikely to last. Firstly, the strong demand during lockdown for a range of goods from iPads to fitness equipment will wane, if only because there are only so many dumbbells a household can use; secondly, businesses will do what businesses do and respond with more supply. Indeed, they already are – the total value of global exports was already at a record high in the second quarter, based on data from the World Trade Organisation. 

What does this mean for inflation? As we are seeing, at first the shortages cause inflation to spike. Companies producing a commodity good” – a second-hand car for example – will gouge the highest price they can (take the money and run); companies producing a product with a valuable consumer brand and repeat customers will not rush to raise prices and/or will lengthen delivery times. In either event, once the pent-up demand from Covid subsides, we are likely to see the prices for goods stabilise in the face of adequate real-world supply. 

The big unknown is what will happen to wages. In his article, Brian Griffiths points out that “In all advanced economies there is a general shortage of labour.” This fact was acknowledged by Jerome Powell, chairman of the US Federal Reserve, in comments last Friday, “The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation…Supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages.” The reasons behind the current labour shortages are mysterious. Theories abound, including the widely held view that the experience of lockdown has caused workers to re-evaluate their work-life balance. What we do know is that in a recent McKinsey survey, 40 per cent of employees stated that they are at least somewhat willing to leave their current jobs in the next three to six months. This finding held across all five countries surveyed (Australia, Canada, Singapore, the UK, and the US) and across industries. In the US the “Quits Rate” – the number of workers voluntarily handing in notices – is at an all-time high. The Rudd paper suggests this is something rate-setters should pay attention to. 

What does this all mean for interest rates? In the real economy prices for goods are likely to stabilise as supply and demand come more into balance. Prices may even fall (deflation) if the current period of above average demand is followed by a dip below trend next year. Labour markets are tight but the causes of this are murky. The Bank of England survey later this month will show that (in reaction to high inflation over the last 12 months) households expect high inflation next year. The bond market already expects higher inflation, pricing in an interest rate hike by year end, with further increases in 2022. If the Bank believes inflation to be driven by expectations, it will raise rates. However, if expectations of inflation prove exaggerated, a rate hike could end up damaging the economy. One thing we can confidently expect is more debate about expectations and their role as a driver of inflation.

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