The collapse in European bond yields has been truly historic this year, with German 10-year bunds now hovering around 0.9%. Danger lights are flashing. There are obvious explanations: above all, growing deflation fears, as well as faltering economic data and Draghi’s comments last week about fiscal support and QE. Add to that some safe-haven related flows because of fighting in Ukraine. The ECB is now in full alarm mode because inflation expectations are dropping rapidly.
The terrifying thing about deflation is that expectations of falling prices can feed on themselves and become self-fulfilling, creating a chain reaction of deep problems in a modern economy.. The question is what can policymakers do about it.
The dirty secret about modern central banking is that monetary theorists understand very little about the process of expectation formation. That is why so much policy debate drifts into irrelevance.
Economic policymakers usually turn it into a debate about credibility, stemming from the Kydland-Prescott academic tradition which focuses on time consistency and credible commitments. It is often rational to break previous commitments, so why should anyone believe current promises? It also gets linked to another somewhat stale debate about “adaptive” versus “rational” expectations. For example, much of the difference in opinion on the FOMC come down in practice to disagreement about how forward-looking rather than backward-looking consumers are when it comes to inflation expectations. Do consumers and businesses just observe the recent trend, or anticipate problems before they arrive?
The amount of actual empirical work on the matter in all this is negligible, however. It is mostly prescriptive theory rather than descriptive or experimental work. And thinking generally about credibility in policy debates tends to be sloppy, with dozens of traps. One major lesson is credibility is heavily dependent on the context, not something you can apply to any situation.
The importance of expectations has, however, led to much more emphasis on policy communication in the last few years, as a matter of practical necessity (and desperation). Monetary policy has become more like theater than math or engineering. How can you sound more credible? How can you make statements believable? How can you get people to understand your approach? Hence Yellen’s endless communication committee work on the FOMC before taking the top job.
But the deeper truth is academic economists just don’t have the skills or tools to understand much about communication, because of course it falls into psychology and organizational science and rhetoric and persuasion instead. Parsimonious mathematical models are not adequate guides in these realms. And people can reasonably doubt whether policymakers have the skill and capability to deliver, whatever their intentions may be.
Instead, it comes down to asking why people change their minds. That is my main focus in policy issues. Everyone knows from their own experience that attitude change is often a drawn-out, fraught, conflicted process. People often see only what they want to see for long periods of time. They can be influenced by networks and relationships and trust, by familiarity and the salience of issues within their larger sphere. They observe facts, but can explain them away or ignore them. (Watch any tv political debate.) There are long time lags and considerable inertia. And many people never change their beliefs at all, regardless of the evidence.
It is also a classic stock-and-flow systems problem. Inflation expectations in particular are usually very sticky, and take a long time to change. Think of a bathtub: it potentially takes a lot of drip-drip information (flow) to change the amount of water in the bathtub (stock), but the system can also suddenly change abruptly (the bathtub overflows.) People frequently forget that many policy issues have major stocks -i.e bathtubs, sinks, buffers – contained within them and so do not react in a linear way to marginal change. There are complex positive and negative feedback loops, and decisive events can change things rapidly. Expectations aren’t simply “adaptive” or “rational” but complex.
Policy tools like fiscal policy and QE most likely do not make much difference to consumer expectations, certainly in the short term. Just ask the Japanese how successful QE and massive fiscal spending has been in putting their economy back on a sustained growth path.
Because there is so much inertia in inflation expectations, it’s more likely that after a few months European expectations will drift back towards 2% again, and the ECB will claim the credit for something they had little to do with. But if inflation expectations really are becoming destabilized, it could take five or ten years and vast pain to fix the problem.