The New Expectations Revolution

Sumner writes his manifesto.

In the 70’s they discovered expectations mattered. Since then “expectations are important” has been muttered towards the end of macro lectures but the idea hasn’t sunk in. Sumner wants to make expectations the central concept of the discipline.

Expected future outcomes (like inflation and output) determine today’s outcomes via the capital markets. His big insight is that the capital markets are the best measure of those expectations. The only expectations that matter are the ones that market participants have. They’re the ones setting wage contracts and prices. If market participants have the “wrong” expectations, prices and wage contracts will be “wrong” too and outcomes will be “wrong” anyway.

This means the solution to the business cycle — at least the part caused by nominal shocks — is to change policy so expectations and the target line up. First, the Fed has to convince itself that it can control the nominal level of output. Once they’re convinced, we’ll be convinced by them successfully moving policy to align expectations to their target. Once we’re convinced that policy will always be such that expected outcomes are the Feds target, then it’ll be so and nominal outcomes will be more or less constantly growing.

Good stuff. But what’s next?

This makes me wonder if the Fed has time varying credibility. If real output moves a little bit, the Fed can be expected to do the little that needs to be done to keep nominal output constant. But what happens when there’s a large shock to real output? Will the public believe the Fed will take the extraordinary actions needed to keep nominal output constant? Credibility is earned by the public observing the Fed follow-up on what it says it will do. The extraordinary actions have never been observed before by definition.

Is this what happened last Fall? Perhaps no Fed policy would have been credible under those extraordinary conditions.

5 thoughts on “The New Expectations Revolution”

  1. Here’s the problem I have with talking about what “the market” thinks of future inflation or NGDP: no one knows what the fundamentals are. If you want to say what the price of say, the stock of some firm “should” be in theory, given rationality, perfect foresight and all that, it should be equal to the PV of future dividends. And you can imagine some person out there, say maybe a company insider or a super stock picker like a Buffett, who knows exactly what product demand, costs, etc will be, and therefore can figure out what the dividend stream will be, and therefore what the “right” stock price should be. And through the magic of efficient markets, the “truth” will somehow get disseminated and incorporated into the market price.

    Now when it comes to inflation, is there anyone who knows what the true fundamentals are? The man in the street? CEOs? Wall Street economists, the ones who produce all those forecasts? Or academics? It seems to me they’re all basically doing some sort of time-series regression. Which is fine for what it is, but can anyone say that they have an edge in that? Or to put it another way: we’ve studied VARs, time series, and all that. Which makes us more or less equal in technique to the CBO, professional forecasters, etc. When it comes to predicting inflation, our training should make us better experts than 99% of the people out there – but speaking for myself, I still have no idea of where it actually comes from. And when guys like Sumner say that “the market” has the right expectation, well then there should be some people out there who know more than we (and our professors, etc) do. But who are they?

  2. I don’t get your views on epistemology. Why can’t the collective “know” more than individuals in that collective?

    Isn’t this why we have undergrads read “I, pencil”?

  3. The very fact that someone was able to write an “I, Pencil” shows that it was possible for someone to understand the entire mechanism of pencil making, to trace every step as it occurs in the real world. Now suppose someone set out to write “I, Inflation”. Who could conceivably write such a thing? Professional economists, if anyone can… in short, people like us (almost). But when I think of all the stuff I’ve learned on inflation… VARs, sticky prices, Taylor rules, central bank credibility… but how does that translate into the actions of millions of people and firms? I wouldn’t bet money on my level of understanding. And neither do most CEOs and firms, from what I’ve seen. One group of people who are willing to bet on their inflation perceptions are gold bugs, which is why gold is so high (and also inconsistent with all the other market-based measures of inflation expectations). But if no one is willing to bet, then how can you put any faith in a “market” predictor?

  4. Is your question about how we measure market expectations?

    In any case, even if we had the best models in the world that could predict inflation 100 years out to the tenth decimal place, it wouldn’t matter. If market participants think inflation is going up next year (even if our ubermodels say otherwise), they’ll write that guess into their contracts. Those contracts are what make nominal business cycles an issue in the first place (sticky whatevers).

    Lucky for us, we can observe some of those contracts by looking at capital markets. Sumner says we should have market participants bet on future macro variables directly (wasn’t somebody pushing macro contracts like these…)

Comments are closed.