Inflation expectations: A Keynesian story after all

The stronger-than-expected jobs growth and an unemployment rate near a five-decade low of 3.6 percent on Friday (8 July 2022) underscores a tight labour market. Furthermore, employers continued to raise wages steadily as average hourly earnings increased 0.3 percent in June and three-month average rate of annual wage growth was 6.1 percent in May, according to the Atlanta Fed, double of what it was a year ago. And unlike previous decades, wage gains have been well distributed between both white and blue- collar workers.

These two metrics viz. wage inflation and unemployment rate were presented in a stylized manner in the form of a Phillips Curve by LSE Professor A.W. Phillips (Keynesian economist) who is credited for presenting the case of an inverse relationship between wage inflation (nominal wage increase) and unemployment rate. When an economy grows, inflation is higher and hence more jobs are created and hence lesser unemployment. This was challenged by Milton Friedman (Monetarist economist) who stated that as per natural rate hypothesis, there must be a certain level of unemployment in a free labour market which is unavoidable. The natural rate hypothesis, argues that while there may exist a trade-off between inflation and unemployment rate in the short run, no trade-off is present in the long run and thus in the long run Phillips Curve is vertical. The underlying assumption in natural rate hypothesis is that economic agents make their predictions based on?adaptive expectations.

Adaptive expectations (AE) is an economic theory which gives importance to past events in predicting future outcomes. A common application is for predicting inflation where AE posits that if inflation increased in the past year, people will expect a higher rate of inflation in the next year. The model has been criticised as being one-dimensional, as in the real world, past data is only one of many factors that is supposed to influence future forecasts of inflation.

These limitations led to the development of rational expectations (RE) economic theory which incorporated three factors: available information, past experience, and human reasoning for forecasting. RE?posits that economic agents should use all the information they have about how the economy operates to make predictions about economic variables in the future. RE suggests that although people may be wrong some of the time, on average they will be correct i.e. at a macro level decision making outweighs micro level decision making. Additionally, it assumes that people learn from past mistakes and the forecasts improve over time. Under RE, if people know that expansionary fiscal or monetary policy will cause inflation in the long-run, they will factor that into their expectations immediately?by expecting higher inflation with no effect on GDP or unemployment. What this means is that there is no Phillips Curve trade-off in either the long-run or the short-run.

These ideas were formalized by John Muth (New Classical economist), who said?expectations are rational if they produce predictions equal to the predictions of the underlying economic model. However, rational expectations rely on the average consumer having remarkably strong economic insight, knowledge as well as being rational and not being swayed by subjectivity- all of which don't necessarily translate as elegantly into real life as they do in mathematical equations.

“The main idea behind the RE hypothesis is to consistently extend the principle of individual rationality from the problem of the allocation of resources to that of the formation of expectations. The individual is supposed to use all of the available pertinent information when formulating his forecast of prices, interest rates, and even government policies”, wrote Nikolay Gertchev in a highly regarded review of the Expectations theories.

“To assume that individuals systematically and unmistakably anticipate the future implies that the future is systematically and unmistakably known to them at the very moment of action. If this were true, individuals would be automatons”,?Nikolay Gertchev further observed.

If economic agents learnt from their past and were rational, we wouldn't have witnessed the current persistent trade-off between wage inflation and unemployment rate and it indeed caught the Central banks off guard as they deemed a repeat of GFC (Great Financial Crisis of 2008) and hence termed inflation "transitory" and were behind the curve in swift inflation management. With nearly more than a decade of ultra loose monetary policy being the norm and a near flat Phillips Curve (when the rate of inflation is insensitive to how hot or cold the economy is) many leading economists are coming to a conclusion that the inverse relationship between employment and inflation as posited by A.W. Phillips, is getting much stronger as the era of cheap money comes to an end.

References:

Gertchev, N. 2007. A Critique of Adaptive and Rational Expectations.?Quarterly Journal Austrian Econ?10: 313-329

Lucas, R.E. 1972. Expectations and the Neutrality of Money.?Journal of Economic Theory?4: 103-24.

Maarten, J. C. W. 1993. Microfoundations: A Critical Inquiry. Routledge.

Muth, J. F. 1961. Rational Expectations and the Theory of Price Movements.?Econometrica?29 (3): 315-35.