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.