Central Bankers Are Handcuffed by Old Narratives

In the space of a few short months, the prevailing narrative on U.S. inflation has veered from “It’s transitory” to “We have a problem.” This week, the Federal Reserve took another step toward acknowledging this, raising its policy rate by 50 basis points and leading investors to expect a faster pace of tightening from now on. That’s fine, you might say, the facts have changed – and to paraphrase John Maynard Keynes, when the facts change, you change your story. What’s interesting is that the story has changed more abruptly than the facts.

Economic policy seems especially susceptible to a certain dynamic. Ideas get fixed too firmly and for too long, so when they’re forced to change, the shift is violent. Narratives drive decisions, and stories shape events, rather than the other way round. The new account of inflation is an arresting example.

Yale’s Robert Shiller discussed the phenomenon in his 2019 book “Narrative Economics.” Writing before Covid-19, he proposed an analogy with epidemics. Frequently recurring infections include real-estate booms and busts, stock market bubbles and crashes, “boycotts, profiteers and evil business” and “the wage-price spiral and evil unions.” These and other tales can go viral, guiding both behavior and policy, directly or indirectly – validating themselves perhaps for years until they give way all at once to a new story.

Such epidemics certainly aren’t confined to finance and economics, as anybody glancing at Twitter can see, but they’re especially powerful in the economic domain because expectations are so central to economic decision-making.

The pivot in thinking on inflation wasn’t a timely course correction made in light of new data: In recent years, more has been at issue in debates over monetary policy than the latest figures on prices, output and jobs. Systems of claims amounting to different views of the world have been in contention. One came to dominate, and for longer than you’d expect, it recruited every new particle of data to its side. Without giving way, it was gradually undermined by news that didn’t quite fit. All of a sudden, it no longer worked, and a new narrative took its place.