Expectations: a weak lever

My claim that expectations are a weak lever for policy has been questioned. Nick says:

Expectations matter a lot for the demand for long-lived assets, and hence for the price of long-lived assets. The lower the rate of interest, the more expectations matter. What happens this year doesn't matter very much at all (unless it affects expectations of future years), and it matters even less as the rate of interest gets lower.

This seems reasonable. But it has an implication which doesn't always fit the facts. It implies that as long-term real interest rates fall, the price of "growth" stocks should rise relative to value stocks. This is because growth stocks - by definition - are expected to offer more future cashflows than value ones, and lower interest rates raise the value of future cashflows. But my chart shows that this isn't always so. Between 2007 and 2010, growth stocks did indeed out-perform as index-linked yields fell. But since 2011 they have not done so. This tells us that the link between longer-lived assets and interest rates isn't as simple as theory tells us. This might be because the stock market is short-termist (pdf) and so longer-term expectations just don't matter much.

This, though, was not the main point I had in mind. I was thinking instead of my second chart, which shows NOP's survey of the public's expectations for inflation in the following 12 months.This chart shows three things:

1. Expectations are not well anchored to the 2% target. Instead, as Adam Posen has said (pdf), they are determined more by the recent data. This poses the question: if the inflation target does not much affect short-term inflation expectations, why should we suppose that an NGDP target would much affect short-term NGDP expectations?

2. Inflation expectations have been above 3% since May 2010. This implies that the public has expected sharply negative real interest rates. But this has not led to the rise in consumer spending that theory predicts.In January 2011, the consensus expected real consumer spending to grow 1.2%. In fact it fell 1.2%.

3.Nor have high inflation expectations led to higher wage growth; average earnings have risen 1.4% a year in nominal terms in the last two years.

These three facts imply that there are two weaknesses in the expectations lever; the Bank cannot easily affect short-term expectations, and such expectations don't obviously have the effects on macroeconomic aggregates that one might think.

Now, I agree that, in theory, policy credibility matters. And I don't doubt that there are times and places when policy-makers can affect expectations; I suspect they have more influence upon financial market expectations than real people's. I fear, though, that economists who invoke "expectations" and "credibility" are making the error of mistaking the tidy maps of models for the messy terrain of reality.

I do not say this to reject NGDP targets. Instead, it is to say that - insofar as these have merit for the UK economy here and now - it is because they would lead to a greater monetary stimulus, rather than because they would affect expectations and hence behaviour.

Comments

[Paolo Siciliani]

I guess I shall note that point 2 and 3 just prove my point that with expected rising inflation but depressed wages due to a slack labour market, consumption will fall rather than grow regardless of negative real interests rates. This paradox of thrift is down to indebted private households acting in a Ricardian fashion by cutting consumption in order to save enough to keep on deleveraging. This though will further depress aggregate demand and hit growth which will viciously strenghten households concerns that salaries won't keep up, welfare benefits will be cut further or they will lose their job.....
In a world where everyone is committed to boost their export (i.e., improve competitiveness - aka fallacy of composition) in an attempt to export their crisis this is a recipe for disaster. By the way, I'd like to note that the current UK goverment was the first one to lead the way on this route, even calling on European partners to follow its example and improve competitiveness, which they all did, as shown by the fact that the pound is at a 22-month record against the Euro, well done all.

[anon]

Inflation expectations are high because the BoE is compromising on its 2% inflation target in order to boost nominal aggregates (cet. par., including NGDP) and bring them closer to the pre-crisis trend, and the markets know this. Wages are just not very relevant; real incomes are the variable you'd want to expand, and that will depend on hours-worked.

[Nick Rowe]

Chris: Thanks for the response!

0. When a recession hits, my guess is that the expected growth rate of earnings on stocks gets revised down. That seems reasonable. So you have two effects going on at the same time: lower interest rates (which should have a bigger effect on the prices of stocks with higher expected earnings growth); lower expected growth rates of earnings (will there be a bigger drop in expected earnings growth for high growth stocks?).

1. Is the BoE really still targeting 2% inflation? Core or headline? Does it say it will do whatever it takes to get headline inflation to 2%? Or does it say it will accommodate VAT increases and oil price increases etc. and let them pass through into headline?

2. Low real interest rates are a *consequence* of the recession. If people expect lower real income growth, they will reduce consumption demand, and that reduces the natural rate of interest. If firms expect lower real income growth, they will reduce investment demand, and that too will reduce the natural rate of interest. Given what is happening in the Eurozone, etc., is it plausible to say that UK people and firms expect lower real income growth?

3. Given VAT increases, and oil price increases, wouldn't we expect falling real wages?

4. Some economists (like Paul Krugman) want central banks to increase expected inflation temporarily. That might help, but a higher expected level for NGDP should help more. Ideally, we would want people and firms to expect a higher future level of *real* income. But targeting real GDP can't be done, of course (been there, done that, it failed in the 1970's). Think of an NGDP target as half way between targeting a higher future price level and targeting a higher future real GDP level.

[chris]

Thanks for commenting, Nick.
The Bank is accommodating higher inflation, which is why I've called it a closet NGDP targeter, in which case the difference between our present policy and formal NGDP targeting is small.
You ask: "Given what is happening in the Eurozone, etc., is it plausible to say that UK people and firms expect lower real income growth?" I think it is plausible, and is one reason why spending hasn't responded much to negative real rates. But I don't see how an NGDP target in itself would change this.
Of course, higher income expectations would help boost spending, but I see no strong reason to suppose that simply changing policy to target NGDP would achieve this.

[Keith]

Paolo Siciliani's summary is very good. Economic policy is like a joint suicide note. Lets out do herbert hoover.

[Alex]

I do wonder if Osborne has succeeded in setting the public's expectations to "deflation and unemployment", which would explain why his policy has kicked in even before much of the actual cut...

After all, a Tory chancellor does have the capability to put you on the dole and a history of doing so, and capability + intent = credibility.

[Paolo Siciliani]

http://www.telegraph.co.uk/finance/economics/9250693/Bank-of-England-could-be-hurting-recovery-with-QE-report-warns.html

There you go, it has gone mainstream, finally. Covered in the FT as well. Anyway, whilst I agree with the diagnosis, I am not sure I agree with the cure. The article recommends tightening the monetary stance, whereas I think the solution is more political. Supply-side policies to raise labour flexibility will increase the sense of precariousness and reinforce the Ricardian vicious circle. So, counterintuitively, we need to move in the opposite direction.

[Nick Rowe]

Chris: "The Bank is accommodating higher inflation, which is why I've called it a closet NGDP targeter, in which case the difference between our present policy and formal NGDP targeting is small."

I think you are partly right on this. (And thank God the BoE is at least partly a closet NGDP targeter, otherwise monetary policy would have been even tighter than it has been.)

But I think you are partly wrong too. Remember the "level-path" bit in NGDP level-path targeting. Sure, IIRC, NGDP is growing at around 5%(?) in the UK, which is fine. But the *level* of NGDP is (I think) a lot lower than the pre-recession 5% trend path. NGDP was growing at 5%, then there was a step drop down, then it resumed growing at 5%, *but didn't return to its previous trend path*. Us NGDP targeters want to get back to that trend path. We think it takes a long time for the real economy to adjust to a step down.

Alex: It's great to have you (sort of) on my side for once! I take back everything I once said about the people of the concrete steps speaking with Yorkshire accents!

Paolo: remember: capitalists are people too! Do we not cut our spending (on consumption+investment), when our incomes or expected future incomes fall? Do we not bleed too? It's all income, not wages per hour.

[Paolo Siciliani]

What do you mean? Non-financial corporations are not investing their cash reserves because they anticipate sluggish demand and because the export drive is not working, at least in the UK, is it? This is part of the same vicious self-fullfilling madness, because in the end profits will start to suffer too (as reported in a previous blog posted by Chris) and everyone (read, CBI-like lobbyists) will start screaming that the situation is getting worse, profit margin are low, we need more supply-side reforms, lower corporate taxes paid by more austerity, which, incidentally, will actually send the all economy even more in the dolddrum. Really, when you talk about working longer hours I am lost for words, who do you think is going to buy the incremental output produced with longer hours, Martians?

[anon]

Paolo Siciliani, if corporations (both financial and non-financial) are not investing their cash reserves, that means they're not adding to inflation pressures either. So the BOE can expand monetary policy to make up for the AD shortfall, without stoking inflation pressures. But if there is a negative supply shock, the central bank might opt to let AD contract in order to defend its inflation target. In that case we'd get a recession.

Who's going to buy the increased output from longer work hours? Well, we might trade it among ourselves, or the pound could fall wrt. other currencies and we might sell it to foreigners.

[Paolo Siciliani]

Trade among ourselves, with disposable income under squeeze and expectations for more to come? Sell it to foreigners, when every trading partner is trying the same trick and actually the pound is appreciating against the Euro? What are you talking about?

[Nick Rowe]

Paolo: Jeez! I am talking about increasing *demand* not supply! Never mind.

Chris: my further thoughts: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/05/is-y-backward-looking-or-forward-looking.html

[Nick Rowe]

When supply is not a constraint (like in a recession) demand *creates* the very income that can afford to buy that same level of demand! All Keynesians (should) know this.

[Paolo Siciliani]

People, let's get to the bottom of this, because this debate sounds a lot like circular reasoning to me. Commenting to the previous post you wrote ""If actual NGDP falls below the target path, people will expect temporarily higher than normal inflation and/or real GDP growth, both of which would make demand higher than it otherwise would be, and help prevent actual NGDP falling as much as it otherwise would." As I argued and showed in this post, in the UK we had temporary high inflation but falling consumption due to household real incomes under squeeze (because salaries are not keeping up and expectations are for more to come), which doesn't fit your story, does it? Now, please explain me how you propose to increase demand that 'creates' the very income otherwise....jeez.

[anon]

Paolo; first of all, consumption is not the only thing that matters in AD. Secondly, inflation can only result from either of two things: (1) an increase in aggregate demand, such as due to monetary expansion; or (2) a decrease in aggregate supply (the economy's productive potential) and increasing costs. When real incomes fail to keep up with inflation, that indicates a supply-side problem which demand-side policy cannot address except perhaps in an indirect way (i.e. by bringing AD back into balance and avoiding further nominal shocks).

[Paolo Siciliani]

Cam'on, don't be patronising. Investment is sluggish because of depressed aggregate demand, and the export drive is not materialising. Real incomes have been under squeeze because they have not kept up with inflation - apparently driven by exogenous one offs, in a long sequence - and because the labour market is sluggish, due to low aggregate demand. So it's not a supply-side problem, I remember settling this this issue down with you time ago, but this must be a zombie argument, it keeps on propping up, regardless of how many times you put it to sleep.

[anon]

Paolo, yes, investment is strongly effected by _future expected_ AD--hence why a level target policy will probably work. Moreover, I agree that we're probably dealing with _both_ AS and AD problems here, and that the AD problem should ideally be addressed even though doing that means accepting that inflation numbers will seemingly be worse.

However, I do claim that an increase in prices with no corresponding increase in nominal incomes (NGDP) indicates a problem on the supply side. Low AD on its own (including slack in the labor market) would be expected to lower all sorts of prices, especially in the non-tradables sector.

I don't mean to sound conceited here--this is almost like Macro 101; but really, folk beliefs are not enough, and it's important to really think through this stuff.

[Paolo Siciliani]

"Low AD on its own (including slack in the labor market) would be expected to lower all sorts of prices, especially in the non-tradables sector." Wrong, there are key non-tradable household budget items that are by and large price inelastic: utilities and telecommunications, petrol or public transport, rent or mortgage and so on and so fort.
You have to think about Micro 101 too, perfect competition is the rare exception not the rule.

[Michelle]

es138: if you think about it, almost all great diorsvecies (good or bad ones alike, as long as it had longstanding consequences) were committed by loners. not just science. in religion it is the same.no one can bloat too much of these things nowadays, either a beer blows it away or it's time to look for the next project, grant, job but there's no need for that loft loneliness really, we're all very lonely anyway. underneath the busy roles we play everyday (I like the TV series : 6 feet under, twisted stuff).at least my life is quite miserable. as it's always been. no need to aim for worse btw, I think woit is a whiner and doesn't do anything worthy.