Inflation: Another failure of the economic profession
It has been a long bumpy road dealing with the inflation surge, and it’s not over. Yet, a few lessons have already been learned, or rather relearned. Here is my list.
1. Wishful thinking beats rational expectations.
First it was going to be temporary. Then interest rates were going to rise a little. Then they will have to rise further but the hikes will be soon reversed. Now it’s high for long. At each step, central banks and financial markets have made quasi-identical forecasts, pronounced with great confidence, and they have been wrong, and wrong again. Central banks have long been known to avoid being a party-pooper. Over 2021, they were keen to support the budding recovery from the long freeze imposed by the Covid pandemic. They were hoping that all would go well, and their hopes were justified by their forecasts. Or, the other way round, their forecasts reflected their hope. The financial markets had spent the previous decade adapting to low-for-long interest rates and hyper-abundant liquidities. They did not want to change again their well-honed business models, so they were keen to buy the soothing pronouncements of central banks, and to sheepishly repeat them.
2. Economists have a short memory.
Inflation disappeared from the radar screens during the 1980s. Economists trained over the next quarter century regarded inflation as a thing of the past, totally uninteresting. Phillips curves were declared flat, and that was it. Old-timers who mentioned the wage-price spiral were summarily dismissed as they ignored the credibility of central banks. Credibility, in turn, was confirmed by measures of inflation expectations extracted from yield curves, which reflected the market’s wishful thinking. ‘Temporary’ was buttressed by rapid declines in real wages, even though it was known that wages and unemployment are lagged indicators. The labor supply curve had vanished, implying that employees would shrug at their lost purchasing power. Rational employees were supposed to accept that the surge in energy prices represent an income transfer to producers. It did not matter that, meanwhile, profits were exploding in sectors that benefitted from these price increases. Well, theory and experience suggest that irrational employees will want be made whole, and will eventually succeed.
3. Fragile complicated models obfuscate robust simple models.
Over the last two decades, central banks had ditched their old models to adopt DSGE models. These models are based on disputable assumptions that emphasize rational optimal behavior and incorporate parameters chosen to ‘match observations’, a fuzzy concept that dispenses with estimation and formal testing. This nicely fits the identification crisis in econometrics, which declares most estimates as unreliable, but do we know that the assumed parameters are reliable? Moreover, these models are driven by assumed long-run inflation expectations, which are set at the inflation target in two- or three-year’s time. This is in line with forecasts extracted from yield curves, that have been systematically wrong. All of that is internally consistent but based on misleading assumptions. Simple AD-AS three-equation models, especially those that featured backward-looking Phillips curves, were seen as antiquated. As recently shown by Blanchard and Bernanke, these models do a good job at explaining what is happening, but this is ex post wisdom by authors who had been keen not to previously criticize the DSGE models, which they have endorsed in their previous incarnations. Maybe this could have been picked up ex ante?
4. Independent central banks must be rigorously accountable.
Central bank independence has been a crucial step toward good monetary policy making. Decisions are taken by monetary policy committees that bring together highly competent economists free from political influence. How then did they all fall in the ‘temporary trap’ and subsequent forecasting errors? The official answer is that these are exceptional times. Right on. But then why did they believe their staff, which came over and over again with results from their models that ignored things like pandemics and lockdowns, massive accumulated savings, global supply-chain disturbances, and later the Russian invasion of Ukraine? It was too obvious that these models would not be able to make any reliable prediction. Few are the monetary policy committee members who publicly rebelled against such nonsense. There are several possible explanations: domination by the governor or a by subset of the committee, silo thinking, limited competence that stunts criticism, or communication dominated by the intention to project collegial agreement. Independence, however, requires constant rigorous oversight and not just ex post justification. The purpose of committee decision-making is to bring together different viewpoints. It is incumbent on monetary policy committees to be transparent so that outsiders can weigh in on internal debates. This is especially so as financial markets are able to influence the committees.
5. Governments should mind their business.
It is understandable that many governments sought to alleviate the impact of the pandemic and the subsequent events on their citizens least able to withstand the shocks. The ensuing large budget deficits arguably played an important role in the buildup of inflation. The central banks should have identified this implication and acted upon it in good time. However, many governments provided subsidies designed to limit the inflationary impact of the energy and food crisis and of the supply-chain disruptions on the domestic price level. Governments are not on charge of the price level and they ought to refrain from attempts to manipulate inflation. They may be rightly concerned with hardships affecting some citizens and with distributive effects of major shocks. The solution is to adopt precisely targeted measures, including subsidies, not to provide universal support to all citizens. Because these non-targeted measures are temporary in nature, they mostly change the time profile of inflation, which greatly complicates the task of central banks.
6. Inflation targeting remains the best monetary policy strategy, but it can fail occasionally.
Until 2021, for about three decades, inflation targeting has proved its mettle. It is based on inflation forecasts, which generally have been reasonably accurate when shocks were few and moderate. When the forecasts became highly uncertain and eventually wrong, the strategy has veered off. This is the weakness of the strategy. This weakness has been magnified by the time is has taken most central banks to recognize that their forecasts could only be inaccurate and to tweak the strategy accordingly. None of that justifies throwing the baby out of with the bath water and discard the inflation targeting strategy. Before the pandemic, the Fed and other central banks announced that they would target average inflation over a medium to long horizon. It looked right at a time when central banks had run out of ammunitions in their efforts to raise inflation to their targets, since they had brought their interest rates to their lowest possible levels. It was a clever way to try and lift inflation expectations. In retrospect, it was not a good idea, and it is now looking desperately implausible since it implies many years of very low, quite possibly negative, in the future. This was a tactical tweak designed to cope with a particular episode, not a strategic improvement. What is needed now is a serious reflection on how to deal with uncertainty when it becomes large.
7. Economists should be humble.
The forecasting debacle should not have happened. It concerns the path of inflation, but also repeated announcements of a hard landing that has yet to occur. There was ample reason to expect that unusual events produce unusual effects that forecasting tools, from formal models to forecasters’ intuitions, would miss. It is hard to understand why forecasters do not systematically publish standard deviations. Standard deviations would have been erroneous for the same reasons, but this is good practice anyway. They should have recognized the pitfalls of the situation and communicated them very explicitly. More importantly, disagreements should have quickly surfaced. Why none of that happened? One possible reason is that forecasters are loath to admit that they are in the dark, maybe for commercial purposes since this is not what their customers want to hear. They fear that admitting that they don’t know could undermine their credibility. Another possible reason is that they really believe in their models and procedures. Well, it’s time to change beliefs. Yet another possible reason is that it is safe to swim with the swarm, even if it means knowingly going in the wrong direction. It is high time for the profession to accept that the crystal ball is not always functioning. In fact, it is not just forecasters who rallied around mistaken statements. Most pundits, including highly regarded academics and media commentators, joined in what was seen as a consensus, even though a few contrarian views emerged but went ignored. This is not how it should be. Given the massive level of uncertainty, forecasting errors were to be expected. It was incumbent to all those who made public pronouncements to express humility.
As a whole, the profession should have held debates assessing various potential developments rather than back authoritative statements. Ex post, few of those who were wrong recognized the fact. Still, most remain vocal and speak as if they are confident in their ability to get it right. And, guess what, they make it to the front page.
Much the same happened in 2007-8 with the global financial crisis. Although the broad media and the profession glossed over the unforeseen failure at a critical juncture, the broader public noticed. Economists, and the elites in general, have been devalued and populism has flourished. Trump, Brexit, conspiracy theories have followed. I know, causation is not established but, if it is, the price has been enormous. There is no reason to believe that more of that sort will not happen again.