Tuesday, 25 February 2014

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:
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.


  1. I think that the whole subject of 'inflation/deflation expectations' could do with a spring clean.

    When it comes to asset prices then yes - investors have inflationary or deflationary expectations and this drives their behaviour. You don't buy an asset (as an investment as opposed to 'for use') if you think the price won't rise and you don't sell it unless you think the price will or might fall.

    Inflationary expectations concerning retail prices have always IMHO been a canard. Joe Six Pack does not look at what retail prices which affect it WILL be: he justifies his wage claims by reference to what they HAVE been, and the way his purchasing power has been eroded.

    Moreover, the availability of credit has never - as far as I know - driven retail price inflation. You only need credit if you don't have purchasing power from income. However credit has frequently (not always) been the driver of asset price inflation - usually land prices.

    Retail price inflation - contrary to Friedman's dictum - is everywhere and always a fiscal phenomenon, caused either by excessive spending on unproductive activity and assets (eg military); a collapse of the fiscal base (Zimbabwe) or excessive foreign currency debt (Weimar).

    To sum up, the inflationary expectation canard - as applied to consumers - has never had anything to do with retail prices, but has had everything to do with a justification for wage suppression.

    Because there is never a good time to increase wages is there? If the economy is booming, then to do so is 'inflationary' (as though increasing rents and interest rates is not); if if it is flat; then increasing wages will lead to recession; and if the economy is in recession, then to do so will lead to a depression.

    1. Chris,

      Even if some people do not have direct effects they have indirectly. For example, if a person expects a prolonged drop in prices (deflation) he will not purchase a good for resale. That is a direct effect. Yet, someone who watches others not engaging in entrepreneurship activities will either lose his job as a result or, if he does not, he will become more cautious of the future and thus spend much less. This in aggregate will reduce spending; what has been known as the paradox of thrift.

      With regards to your example: this is exactly what I mean by persistence, seeing what prices have been and judging by them.

      Of course it has: for example mortgages have been driving house prices up. These increased housing prices mean higher incomes for builders, realtors and others in the industry, which means they can spend more. More spending means more demand for a given quantity of goods (in the short-run) meaning that prices rise.

      What you are referring to is hyperinflation.

      Wages do not rise because of profits or because of inflation. It's only demand that raises them.