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Thursday, March 15, 2012

Inflation Floodgates All Wet

Simon Wren-Lewis notes that Central Bankers feel that a little inflation is dangerous as it can spiral out of control. The analogy is opening flood gates a crack. He also notes that this view (which actually seems a bit shared by ordinary people in a survey) doesn't fit the facts.
I note that the fears of inflation hawks correspond to my favorite model of expectations so I have inflation hawk egg on my face.

Well score one for the credibility of independent central banks. Yes inflation expectations rose above the target, but not enough to set off Stagflation.

Also score one for pretty much rational expectations (no one takes it literally).

In contrast an own goal for my favorite behavioral model of expectations. I just realized that it corresponds exactly to the floodgates hypothesis. Psychologists including Anreasson and Krause have found that people presented with a random walk make forecasts as if the data were generatged by a broken trend. So generally they predict mean reversion, but a few increases in a row and they decide the variable is trending up, so they extrapolate.

This behavior corresponds exactly to expectations which are currently anchored, but also to floodgates which can open. I think it is reasonably clear that actual central bank policy has something to do with believing in this behavioral model (as I generally do) along with ideas that inflation is sinful and so on.

Anyway, my favorite model of expectations failed this time.

1 comment:

hrsaccount said...

Inflation will
1) FIX the problem of low growth in the US,
2) FIX the problem that Germany is too competitive with southern Europe,
3) Ditto for BRICS vs. US
4) FIX the inequality issue
5) FIX the debt problem
...and so on.

Sounds a little too good to be true doesn't it?