Saturday, April 5, 2014

Inflation predictions are hard, especially about future inflation

Currently reading through Simon Wren-Lewis's post on microfoundations and the Phillips curve. I'm going to have an empirical look at this quote:
First, although various microfounded models suggest inflation should depend on expected inflation next period, the empirical evidence is more equivocal. A number of studies have found that inflation today depends on both expected inflation next period, but also on actual inflation last period (‘inflation inertia’).
Now I don't think very highly of expectations as a long run driver of macro variables (or even microfoundations). In the short run, any influence of expectations is likely to reduce information flow because: 1) who knows anything about the future, 2) the EMH and 3) in financial markets any sort of stock picking behavior tends to under-perform the market. (I guess all three of those are related.)

Anyway, here's a plot of year-out inflation expectations from the Michigan survey (red) alongside previous year-over-year inflation (i.e. prior period, blue) and instantaneous inflation (i.e. d/dt log P, or current period inflation, in gray):


So let's check out a simple model where instantaneous inflation (current period) is the average of expected inflation and past inflation (prior period). The result is in purple in the next graph:


How does this model compare with the simple martingale of using only the prior period inflation? It actually makes it a bit worse. In the graph below, you can see the model error for the martingale (MTG) in blue and the averaging model (AVG) in purple, the latter has a slight linear trend, being low in the 1980s and high in the 2000s (i.e. the trend is non stationary/has a unit root):


In the next graph, I show the error histograms for AVG (purple), MTG (blue) and expectations-only (EXP, red). The positive skew of the averaging model derives almost entirely from the expectations -- therefore any more complicated linear combination of the averaging model, say of the form (1-λ) MTG + λ EXP with 0 ≤ λ ≤ 1, will also have a larger positive skew than MTG by itself.


Overall, inflation expectations are biased toward more inflation than appears and actually throw off the simple prior period inflation heuristic (which itself is slightly slightly biased towards higher inflation than occurs). There are two scenarios (at least) that could account for this:
  1. People are still psychologically affected by the high inflation of the 70s and 80s. This would explain not only the expectations (obviously), but also the trend towards lower inflation due to a central bank staffed with psychologically affected people.
  2. There is an underlying trend towards lower inflation due to e.g. the diminishing impact of monetary expansion (see also here). This would cause even people who used the simple (and fairly accurate) martingale to overshoot inflation, and the Fed to undershoot its de facto if not de jure inflation targets because what worked to achieve 2% inflation in the prior period wouldn't work in the future period.

9 comments:

  1. Jason, regarding "interia" of inflation, have you ever read this?

    http://thefaintofheart.wordpress.com/2013/08/30/inflation-doesnt-have-a-life-of-its-own-i-e-its-not-inertial/

    ReplyDelete
    Replies
    1. I had not ... Nunes is one of the more shall I say faithful of the power monetary policy. I imagine Brazil stopped printing physical currency when it effectively pegged the new real to the dollar -- expectations had no effect. I'd need to find some monetary base data for Brazil that covers the period. (Additionally, developing counties tend to have low information transfer indices, so respond more dramatically to changes in the base.)

      I did look into hyperinflation

      http://informationtransfereconomics.blogspot.com/2013/09/hyperinflation.html

      And I think Nunes is using a verion of "Scott Sumner's model" I put together here

      http://informationtransfereconomics.blogspot.com/2013/08/scott-sumners-model-part-2_30.html

      Delete
    2. Jason, thanks for those links. Very interesting!

      Delete
    3. I just alerted Vincent Cate the (amateur) hyperinflationist to your hyperinflation blog post... so look out! :D

      Delete
  2. Should be "inertia" not "interia" Lol.

    ReplyDelete
  3. Jason, I gather by looking around your blog, that you don't always put much faith in "expectations." True?

    ReplyDelete
    Replies
    1. I find expectations to either be like phlogiston or way too powerful. I'm actually working on a post about how any expectations that deviate from what actually happens destroy information. I believe expectations are fundamental to the business cycle (stock markets fluctuate on them) but the long run trend seems to be set by things like the amount of money or the size of the economy. And expectations can make things deviate only so far.

      Delete
  4. Nick Rowe gives an example showing that if MB is held constant and cash and deposits are complements of each other, then deflation can result with rising deposit rates.

    Nick Edmonds presents a simple model which shows that this can happen if cash and deposits are imperfect substitutes. He has a small error in his final line, which I correct:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/04/deflationary-banks.html?cid=6a00d83451688169e201a73da5ca33970d#comment-6a00d83451688169e201a73da5ca33970d

    This is the kind of thing I'd like to see more of in Nick Rowe's comments. I'm not in a position to evaluate the appropriateness of Nick Edmonds' simple model, but if it is OK over some limited range, this gives us a better picture of exactly when what people say in words applies. A couple comments down Nick Rowe states he thinks that the relative size of the stocks of reserves vs currency [in circulation] making up base money determine whether or not base money is a substitute or a complement of deposits. I'm not exactly sure what he means by that, but given Nick Edmonds' model, I suspect that's not right. I put it this way:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/04/deflationary-banks.html?cid=6a00d83451688169e201a5119b01de970c#comment-6a00d83451688169e201a5119b01de970c

    ReplyDelete
    Replies
    1. This is interesting. I'll have to check it out more closely when I have some more time.

      Delete

Comments are welcome. Please see the Moderation and comment policy.

Also, try to avoid the use of dollar signs as they interfere with my setup of mathjax. I left it set up that way because I think this is funny for an economics blog. You can use € or £ instead.