So, you’re trying to manage inflation…

It’s Fed Day (again) and Jerome Powell and his colleagues at the FOMC are trying to manage monetary policy in such a way that they hit their dual mandate of low inflation and full employment. While trying to target the unobservable real risk-free rate (the infamous r*) one thing that can be measured is inflation expectations – even though there is not that much empirical evidence that inflation expectations have any meaningful relation to future inflation.

But if we follow conventional wisdom and assume that inflation is driven by actual behaviour of consumers and businesses in the real world, and that this behaviour is influenced or even determined by inflation expectations, then we have to ask how consumers form their views about inflation. I am on the record for criticizing all existing theories of inflation (whether they are monetarist, Keynesian or fiscally driven) for being based on rational expectations and discounting future cash flows into the present.

As I said in the article linked above, I think any theory of inflation based on rational expectations or discounting future cash flows is bound to fail in the real world because that is simply not how normal people on the street think and act. Instead, I think we need to develop a behavioural theory of inflation informed by real people and their actions in the real world.

While developing a behavioural theory of inflation is well beyond my capabilities, nor is it something that academics seem particularly interested in at the moment, I am glad to say that my view has received support from a new piece of research.

Peter Andre and his colleagues surveyed more than 10,000 US households and more than 100 experts about the recent surge in inflation and its causes. Below is the key chart from their paper showing the percentage of times different factors appear in the narratives about inflation of households and experts.

Drivers of inflation narratives

Source: Andre et al. (2023)

Let’s look at expert explanations first. The key drivers of the inflation spike in 2021-2023 according to experts was excessive government spending (in particular government spending during the pandemic), supply chain issues and monetary policy. These are the factors that I and every other economist have been debating for the last couple of years ad nauseam. Did the Fed keep rates too low for too long? How much inflation was created from the Covid support packages and the Inflation Reduction Act? How much of the price spikes in oil and other goods are due to supply disruptions? And so on and so forth.

Now, let’s look at how private households form their inflation expectations. Government spending and monetary policy by the Fed hardly featured as an explanation, showing up in just 17% and 5% of all answers.

If you ask households what caused inflation, they will tell you it was the pandemic, government mismanagement, supply chain disruptions and labour shortages. In essence, households form their inflation expectations based on what they experience in their everyday lives. Whether that is a shortage of goods on supermarket shelves or an inability to find qualified workers for a business. Government red tape or the disruptions experienced in pandemic lockdowns. This is what drives inflation expectations of real-life people, not abstract monetary or fiscal policy decided in Washington.

And if you ask me, as long as economists try to explain inflation through abstract actions taken in Washington that most people don’t know about or don’t understand, inflation models will continue to fail.

More importantly, as long as central bankers insist on trying to guide inflation expectations by providing forward guidance about future rate hikes or cuts and similar abstract measures only intelligible to experts, they will fail to influence real life inflation through managing inflation expectations. Instead, they just form their own echo chamber where central bankers talk to other experts about how they think the world works.