Revisiting Inflation Expectations

Last year, after our newly-adopted dog demonstrated her ability to jump over our fence, a neighbor shared a useful anecdote: “Every dog owner will utter the sentence: Wow, we’ve never seen him do that before!” Training is important, but we also must think quickly when confronted with new behavior.

We have uttered similar feelings of surprise and exasperation when digesting economic data since the COVID-19 crisis. Many measures have scaled the fences of our comprehension.

Inflation is one of them. Recent elevated readings on the price level have captured attention and required careful analysis. Economists have often turned to inflation expectations as a reason to look past any one month’s measure of inflation, but also as a guide for when inflation may come. Prices are more likely to rise when there is a widespread expectation of rising prices.

Last week, the practice of using inflation expectations as a guide to future inflation came under question from a researcher at the Federal Reserve. His paper was provocatively entitled: “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?).”

The author argued that relying on expectations is “unnecessary and unsound…[and has] no compelling theoretical or empirical basis and could potentially result in serious policy errors.” A key takeaway was that, in a well-functioning economy, a typical person shouldn’t need to pay much thought to inflation. When asked to measure inflation, professional and lay survey respondents alike tend to overestimate it. Mainstream attention to inflation is a warning sign, and policymakers should manage inflation based on observed evidence, not expectations.