Deflation, Inflation and Expectations

That dis-inflationary pressures have been observed in the Eurozone over the past year is nothing new. They have been so common elsewhere in the world (for example Japan or the US) that news of higher inflation are now being heralded as the dawn of a new, happier era (even though some are more exaggerated than other). Even though deflation has expanded to other measures of prices, the main focus is that we are moving towards higher inflation, with deflation no longer being an issue of concern; at least that's what the ECB is saying.

Trouble is, almost no-one sees it the same way. Tim Hartford, for example, notes that the persistence of low inflation may mean trouble for borrowers, leading to more bankruptcy risk and, God forbid, more non-performing loans to banks. In addition, what I fear most is that low inflation, just like high one, can be embedded in expectations and remain for much longer than we would normally expect, with all the known consequences. This is not just a doomsday scenario; expectations matter much more than we most of the time think when it comes to policy.

A simple example of how much expectations matter is what is usually referred to as reflexivity, a theory that simply put, means that we are in fact creating a part of the world we are trying to forecast; a very similar notion to what has been known as the Lucas Critique in economics. As the world of economics is not governed by the hard rules of physics, what people believe about the future will in fact affect it. In addition, the only way they can make an educated guess on the future is by viewing current events and basing their judgement on experience, meaning that in a way, the future affects the past as well (to be more precise, expectations about the future affect what we do now). 

This is what has been going on at the moment: people see low inflation and have every right to expect low inflation since no measures have been taken against it (the rate cut in late 2013 was really nothing special). It can be seen in the consumer expectations:

Italy's Consumer Confidence Sales (Feb) M/M 97.5 vs. Exp. 98.5 (Prev. 98.0)
— Fabrizio Goria (@FGoria) February 25, 2014

This is led by something more than just expectations about the inflation rate. Peter Praet, (aka Captain Obvious) noted "Weak demand and high unemployment could also be playing a role". You don't say! This is exactly how inflation falls: lower supply of loans from banks means lower demand (for the monetarists out there this means reduced money velocity ); adding high unemployment to that equation means even lower demand. This is not a matter of what affects what; it's a matter of everything affecting everything as, whether policymakers like it or not, people are the economy. It is only if we can convince them that are going to get better that they will.

Here is where the ECB is wrong: people, even subconsciously, trust what you do and not what you claim. As Lech Walesa once said "The supply of words in the world market is plentiful but the demand is falling". Saying we are not in danger from deflation or dis-inflation does not change anything, unless you get people to believe it. And if they are rational (and on average they are as they can see what goes on in the real world), then they won't buy it that easily.