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Irrelevant expectations

In theory, high inflation expectations are a problem. In reality, not so much
August 30, 2017

Should we worry about the possibility of inflation staying above its target? One piece of economic theory says yes, but the facts say otherwise.

Next week, the Bank of England will publish its latest survey of the public’s inflation expectations. This could show that people expect above-target inflation simply because inflation has been high recently. In theory, this points to inflation staying high. This is because ever since Milton Friedman’s famous lecture to the American Economic Association in 1968, economists have believed that inflation expectations help determine actual inflation. As Kevin Hoover explained: “As workers come to anticipate higher rates of price inflation, they supply less labour and insist on increases in wages that keep up with inflation.”

But is this true? The Bank of England’s survey of inflation expectations has been going since 1999, so we can use it to test this claim. If it’s correct, we’d expect to see a positive correlation between inflation expectations and wage growth in the following 12 months. So do we?

No. Quite the opposite. Since the Bank’s survey began there has actually been a strong negative correlation (of 0.59) between households’ inflation expectations and subsequent wage growth. Low inflation expectations in the early 2000s led to high wage growth, but high inflation expectations in 2008 and 2011 led to low wage growth. This negative correlation exists even if we control for other determinants of wage growth such as unemployment or productivity growth – although it becomes statistically insignificant if we control for both of these. What we have is not so much an expectations-augmented Phillips curve as an expectations-diminished one.

Why?

One possibility is that inflation expectations, as the Bank measures them, are just noise – random, ill-thought responses to someone with a clip-board.

This seems unlikely. Aggregate expectations in the Bank’s survey look very sensible. They are consistent with people expecting inflation to be what it has recently been, adjusted upwards if inflation has been unusually low and downwards if it has been unusually high. That seems to me a pretty sensible rule of thumb even if it is short of the full rational expectations theories we were tortured with at university.

There is, however, another explanation. Your beliefs, wants and expectations are only part of what determines what you’ll get. What really matters is power: do you have the power to get what you want?

In the case of workers, the answer is: no. Even if they expect high inflation they don’t have the power to get wage rises. Yes, unemployment is low. But as the Bank of England’s Andy Haldane said in a recent speech, workers are unable to parlay this into pay rises. There are many possible reasons for this: deunionisation; a scarring effect of the recession; increased job insecurity; and so on. Whatever the reason, workers no longer have the power to 'insist' upon pay rises to compensate for price rises. Their inflation expectations are irrelevant.

It's often thought that ours is a post-modern era in which subjective beliefs matter more than facts and reality. This, though, isn’t always the case. The brute hard fact of workers’ lack of power means that what they believe about inflation doesn’t matter.