It was a strong statement to make, that introductory remark of the US Federal Reserve Board’s Jeremy B. Rudd in his 2021 article “Why do we think that inflation expectations matter for inflation? (And should we?).” He argued that “using inflation expectations to explain observed inflation dynamics is unnecessary and unsound: unnecessary because an alternative explanation exists that is equally if not more plausible, and unsound because invoking an expectations channel has no compelling theoretical or empirical basis and could potentially result in serious policy errors.”
He immediately quoted Robert M. Solow who wrote in 1979 that he was “always a little dubious about an appeal to expectations as a causal factor; expectations are by definition a force that you intuitively feel must be ever present and very important but which somehow you are never allowed to observe directly.”
Rudd’s arguments are quite strong, and central banks doing inflation targeting with due concern for how inflation expectations behave should read him carefully.
He laid down the basis of the economists and policy makers for considering inflation expectations in assessing the dynamics of inflation. Theoretical models underpin the view that inflation expectations matter. Such theoretical models help explain the changing relationship between unemployment and inflation. And such theoretical models have led to the inclusion of inflation expectations in estimating inflation, as prior.
For him, the empirical case is weak. As to the theoretical models that assume a role for expected inflation, he observed that they “carried other empirical implications that were clearly at variance with the data.” He thought he demolished Friedman’s argument about the expectations-augmented Phillips curve, the so-called Lucas-Rapping assumption of inflation following a trend-stationary process, and Lucas’ “surprise” model that is supposed to depend on the arbitrary exclusion of current price level from the information set.
Expectations-augmented Phillips curve posits the idea that if actual inflation increases, expected inflation will also go up and the Phillips curve will shift upward. As a result, we would have the same expected real wage increase at each employment level. In the long run, the Phillips curve becomes vertical to show the so-called natural rate of unemployment.
Lucas-Rapping is Robert Lucas and Leonard Rapping, writing in 1969, who attempted to model aggregate supply based on the assumption that expected inflation drops in the presence of unanticipated increase in current inflation.
The Lucas “surprise” model proposed that only random and transitory policy shocks can affect output. Rudd found this unappealing.
In terms of policy implications, Rudd believed that it would be more sensible to refrain from “re-anchoring” people’s expected inflation closer to official target because that could be both “dangerous and counterproductive.” There is greater likelihood that when people start to be preoccupied with inflation, trend inflation might once again begin to respond to changes in business activities. Since inflation expectations cannot be directly measured, that complicates the analysis and projection of inflation. Another unobservable variable is added.
Rudd’s paper may sound rude, but it is best summarized by his abstract: “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.”
Those who would like an alternative view should read the latest version of Jonathan Hazell, Juan Herreño, Emi Nakamura, and Jón Steinsson article “The Slope of the Phillips Curve: Evidence from US States,” published in August 2022 in Oxford’s The Quarterly Journal of Economics.
The driving force of this article is 42-year-old Emi Nakamura of the University of Berkeley who earned his PhD from Harvard and has been collaborating with her economist husband Jón. To her, “there often aren’t enough data points in the macro data to make convincing arguments about causality. Looking at micro data is a natural way to expand the data set.”
This latest study is preceded by at least two related articles with the wife-husband team as mainstays.
On building the case of price changes during regular times or during sales, in their 2008 article “Five Facts about Prices,” they used actual Bureau of Labor Statistics (BLS) micro data to expand the data set to cover the period 1988-2005. That was hard labor because it entailed sifting through reams of dusty paper in windowless room at the BLS, as IMF’s Peter Walker described in Finance and Development (December 2022). By distinguishing between temporary price cuts for sales and regular pricing, Nakamura and Steinsson found that regular prices were stickier than previously established.
Nakamura later on clarified that prices change more frequently during high inflation periods and this should call for more careful monitoring of economy-wide price changes and in designing public policy intervention.
A decade later, in 2018, and for the article “The Elusive Costs of Inflation,” the wife-husband team with other collaborators, gathered more and new micro-data during the higher-inflation period 1977-1988. Data gathering was more intense, involving commissioning a custom-made microfilm converter. This piece of equipment was necessary because about one million images of price trend listings had to be converted from the scanned microfilm cartridges.
This article confirmed that regular prices were indeed adjusted more frequently when inflation was higher, consistent with standard menu cost models. An interesting aspect of the study is their finding that prices have not become more flexible in the last 40 years — not because of technology-related reasons but because of customer-related frictions. Citing Allan Blinder, et al (1998), they explained that firm managers were hesitant to adjust their prices more frequently because they feared antagonizing their customers.
In their latest study of August 2022, they benefitted from an analytical work done by Macro Policy Lab which conducts data-driven and policy-relevant research on macroeconomics. The team estimated the slope of the Phillips curve in the cross section of US states using newly constructed state-level price indices for non-tradeable good as far back as 1978. They found that such a slope was rather small and even smaller in the early 1980s. The decline in the slope further continued since the 1980s which would indicate a weaker relationship between inflation and changes in both output and unemployment.
The authors argued that based on the application of their estimate of the Phillips curve to recent unemployment dynamics, the recent drop in core inflation “was mostly due to shifting expectations about long-run monetary policy as opposed to a steep Phillips curve, and the greater stability of inflation between 1990 and 2020 is mostly due to long-run inflation expectations becoming more firmly anchored.”
What is the rationale for doing all this research around the Phillips curve?
As the authors explained, it is built on the common intuition that if demand is high in a booming economy, this will trigger workers to seek higher wages and firms to jack up prices, both of which could be inflationary. Before and during the great disinflation engineered by former US Fed Chairman Paul Volcker, such a curve was rather steep but started to flatten since then. Under Volcker, the long-run inflation expectations were firmly re-anchored.
This study addressed several reservations put forward against assigning a role for inflation expectations in assessing the prospects of the inflation path including the issues of identification and simultaneity.
Given the lower estimate of the slope of the Phillips curve and the estimate of the persistence of unemployment fluctuations, the authors suggested that only a small fraction of the large changes in inflation in the early 1980s worked through the process. In contrast, as the authors observed, there were large movements in long-run inflation expectations during the same period.
Volcker’s anti-inflation measures must have influenced the rapid decline in inflation expectations and in turn, motivated the disinflation process.
As Nakamura recently explained “The relevance of this for the present context is the emphasis that it puts on long-term inflation expectations and confidence in the monetary regime — maintaining these is key.”
For some economists and policy makers in the Philippines, they would rather dismiss the role of inflation expectations and focus on supply factors, as if government is not doing something about them, and that central banks have the tools to manage them. For others, they thought that managing inflation is a question of moving up and down the Phillips curve, as if adjusting the monetary levers to address inflation and keeping them steady to promote economic growth is a zero-sum game.
It was correct for Bangko Sentral ng Pilipinas (BSP) Governor Philip Medalla to have announced that the BSP may find it hard to cut policy rates because risks continue to haunt the inflation path, including the El Niño and higher wage hikes. This is watered down, however, by those who rejoice in an extended rate pause which poses a disconnect with observed persistently high inflation and the impending adjustments in wages and supply logistics.
As Nakamura stressed, trust in the long-term inflation expectations and confidence in the monetary regime are important. Keeping the choir in harmony is key.
Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.