Central bankers, and even someof the best economists, sometimes talk about inflation expectations becoming ‘unhinged’. I do not like this term, and have been known to react quite badly to it. Some might say overreact. Let me say why.
But before doing so, I want to make three things clear, lest I be misunderstood. First, I think inflation expectations are really important. Second, I largely believe the great moderation story. As a result of setting inflation targets (explicitly or implicitly), and acting to achieve them, central banks did succeed in stabilising inflation expectations at low levels, and this has made the job of stabilising the economy as a whole rather easier. I may be wrong about this, but that is what I currently think. (I chose this as an example of the achievements of the microfoundations revolution in macro in my mild disagreement with Paul Krugman on this issue.) Third, I think it is more than likely that if inflation stays above/below target for some time, inflation expectations will adjust.
But I would not call this expectations becoming unhinged. It is all about language. I would have no problem if another term was used. I used the term ‘adjust’ above, but we could also say ‘increase’, or ‘become less predictable’, or even ‘shift’. In fact any of the other words we normally use for macroeconomic variables. When discussing consumption, we do not talk about expectations of future income becoming unhinged. When discussing exchange rates and UIP, we do not obsess about expectations of future rates being unhinged. Whether intentional or not, the use of the term unhinged is designed to create an impression. The impression is of disastrous uncontrollability. If we talked about a person become unhinged, we indicate madness.
It is as if inflation expectations can be in one of two states: either low variance with mean reversion to the inflation target (or something close to it), or as highly volatile and could go anywhere. In this second imagined state, as expectations of inflation drive actual inflation, we could have ‘inflation bubbles’, which would become very costly for the central bank to prick. As we really do not want to go to that second state, we have to do everything we can to stay in the first state.
It is this view of the world that I find very difficult to believe - in fact I find it absurd. Why would inflation expectations become so unanchored from a central bank’s inflation target? They would do so if people thought the central bank had no intention of trying to achieve that target. So the only circumstances in which inflation expectations might become unhinged are when the central bank itself became unhinged. That could happen if the central bank was ordered to permanently monetise growing budget deficits, but that is not the world we are currently in.
When central bankers talk about unhinged expectations, they nearly always mention the 1970s and early 1980s. Do we really want to go through that again, they ask? Yet that was a period, in the US and UK, when it was very unclear what the central bank’s inflation target was, or indeed whether it had one. (This was not the case for Germany, as I note here.) So the lesson of that time is that inflation targets are important, but not that they should never be changed or missed.
I would draw a very different lesson from that period. It is important not to have taboos in macro. If there was a taboo at that time, it was that rising unemployment would mean a return to the 1930s. This prevented many seeing variations in unemployment as a means of stabilising inflation.
Could it be that we have a similar problem today, except roles have become reversed? With nominal rates at the zero lower bound, and doubts over unconventional monetary policy, we could use higher inflation (raised in a premeditated and controlled way) as a means of getting unemployment down. Of course that entails costs, and so we need to do the cost benefit analysis, and look at alternatives (like fiscal policy) that may be less costly. But if raising inflation is taboo we will not have that discussion. In this context, talk of expectations becoming unhinged reinforces that taboo.
In memory of Mel, who showed even as a teenager an appreciation for the absurd by helping me found the LUWS.
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