A Federal Reserve economist thinks most common sense inflation theories are “arrant nonsense,” whose only function is to “save us from intellectual nihilism.”
“Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense,” writes Fed official Jeremy Rudd in his new report titled Why Do We Think Inflation Expectations Matter for Inflation? “No doubt, one reason why this situation arises is because the economy is a complicated system that is inherently difficult to understand, so propositions like these—even though wrong—are all that saves us from intellectual nihilism.”
Rudd outlines three commonly held beliefs toward the economy, before arguing against the notion of expected inflation as a determining factor in the inflation process.
- Aggregate production functions (and aggregate measures of the capital stock) provide a good way to characterize the economy’s supply side.
- Over a sufficiently long span—specifically, one that allows necessary price adjustments to be made—the economy will return to a state of full market clearing.
- “The theory of household choice provides a solid justification for downward-sloping market demand curves.
In his argument, Rudd points to flawed expected inflation theoretical models developed by Edmund Phelps, Milton Friedman, Robert Lucas and Leonard Rapping. One of the problems with relying on these models, according to Rudd, is that these economists defined expected inflation through a “short run” period, wherein inflation is influenced by “a one-period-ahead expectation.” This sits in direct contrast to current policymakers who pay more attention to “long run inflation expectations” occurring over a multi-decade timeline.
“Even without appealing to empirical arguments… it is clear that none of these models makes a strong case or even especially plausible theoretical case for including expected inflation in an inflation equation,” writes the economist.
The Federal Reserve has used inflation expectations to assess inflation outlook, with many policymakers using the measuring tool to justify certain economic solutions.
“Using inflation expectations to explain observed inflation dynamics is unnecessary and unsound,” says Rudd.
