Anchored Perceived Inflation or How Fox News Helped Obama
This will be a vague confused post related to the question of why the great recession didn’t lead to deflation in the USA. From 2003 through 2007 there was low CPI inflation about 2% to 3%. A huge recession, sluggish recovery and gigantic persistent output gap caused inflation to drop into the range from 1% to 3%. Core PCE inflation (the increase in the deflator of personal consumption excluding food and energy) fell from sticking close to 2% to fluctuating in the range of 1% to 2%. The standard low brow backward looking forecasting equation relates the change in inflation to the output gap. It completely failed to fit the data.
There are two candidate explanations for this surprising behavior of inflation. One is that there is strong downward nominal rigidity — it is very hard to convince firms to cut prices and, especially, to convince workers to accept wage cuts. Importantly, in this story, the change in prices or wages matters not the change minus expected inflation. Decades ago, James Tobin noted that the story can explain persistent low positive inflation if there are many sectors with high demand in some causing rising wages and prices and low demand in others causing zero changes.
Another quite different explanation is that expected future inflation has a very important role in wage and price setting and that inflation expectations are anchored. The story is that people persistently expect future inflation of about 3%. This model requires nominal stickiness, but there is nothing special about zero change in dollar wages. This story is strongly supported by the fact that the median respondent in the Michigan University/IPSOS Reuters survey persistently expected future inflation of almost exactly 3% in almost all surveys since mid 2009.
Notably, in period after period a majority of survey participants have been surprised by actual inflation lower than their forecast. This is a new phenomenon, in the past median forecasts weren’t perfect or even optimal given available data, but they weren’t persistently off in the same direction.
Finally, I get to what I want to add. In theoretical macroeconomics it is assumed that recent past inflation is known to all and not a matter of controversy. In the literature on surveys there is increasing discussion of inflation perceptions as well as inflation forecasts. When people are asked how much prices have increased on average over the past year, they give different answers. They don’t repeat the official estimate. It is clear that many people just don’t believe the official numbers.
For non link clickers, I note that I have linked to two Krugman posts separated only by a friday night music post. But Krugman doesn’t link them. In one post cranks insist that official inflation indices understate inflation. In the other workers and employers are assumed to know about past inflation. I think one very appealing explanation of why workers haven’t accepted markedly lower real wages in spite of persistently high unemployment is that workers are convinced that they have accepted markedly lower real wages because of high unemployment.
I am assuming that, like inflation expectations, inflation perceptions have delinked from reality recently. I really really should find data on perceived inflation (which is out there somewhere). I also have to come up with a story for why this happened just in time to save us from deflation.
I give the credit to Fox news. A large fraction of people in the US rely on Fox News (often indirectly as repeated by friends and relatives). They are out of touch with reality — there expectations and perceptions are what Roger Ailes wants them to be. He thinks inflation is bad even though in a depressed economy in the liquidity trap it is good. Therefore Fox News convinces people that inflation has been and will be high. The representative consumer is only partly living in the Fox bubble so perceived and expected inflation are moderate. Then finally actual inflation is low but positive.
It fits the facts which I reported. You decide.
This is a fascinating thesis.
However inflation seems to be on a long run downward trend which would have the same effect if people used a simple martingale.
I also put together an information-theoretic “quantity theory” model that predicts the trend and inflation today from 2007:
http://informationtransfereconomics.blogspot.com/2014/07/better-than-tips.html
The government numbers are a fantasy. Real price inflation is about 10% a year. And right after the crash, prices shot up by 20-50% and packages got smaller. If you tell me inflation is only 1% then your maid must do the shopping.
“I think one very appealing explanation of why workers haven’t accepted markedly lower real wages in spite of persistently high unemployment is that workers are convinced that they have accepted markedly lower real wages because of high unemployment.
Should that last word be “inflation”?
Consider the Tobin model applied to price inflation. My inflation is not your inflation. 15% food inflation is much more relevant to a family with an income of $25k than to a family with and income of $50k. Market basket selection and the price of that selection drive peoples perception of price inflation.
@Sharonsj – if what you are saying (ranting?) is true, then riddle me this:
1. My monthly budget for food has not increased at all since 2008, in $ or % terms (I’ve had no raises at my job due to the recession). In fact, I’ve not made any major changes to my monthly budget at all for the last 6 years.
2. I still eat roughly the same diet I have for my 19 years of adulthood – moderate fruits & veg, lots of meat and carbs.
3. I’ve stayed the same weight (+/- 5 lbs) for the last decade.
4. I’m not dead.
Under your logic, I should be losing about 10% of my food budget every year to “inflation” or “smaller packaging” or whatnot in my grocery purchases. That should translate to me inadvertently buying fewer ounces of my favorite foods and/or me losing weight. However, if I’m not losing weight and I’m still happily eating away at things I want to eat… where’s the evidence of the damage caused by this “inflation” or “smaller packaging”? If there’s no damage, what’s the problem even if I assume you are correct about inflation/packaging?
@Tom Stickler what I meant was “workers think “I am accepting a sharply lower real wage because of high unemployment” and they think this even though their nominal wages aren’t decreasing because they believe inflation is high”. Not a typo, deeper unclarity.
Larry Signor — you are right about the problem with using one basket for all urban consumers. The thing which struck me was the recent change in the relationship between median Michigan survey forecast inflation and lagged CPI inflation. Relative prices change all the time. A story based on relative prices has to explain why the two series moved together in the past. I think this is quite difficult. I think there is a robust anomaly for the recent period starting about January 20 2009.
Indeed, relative prices and substitution are part of the story, but a much larger part may be inflation expectations. The Cleveland Fed published a study which seems to support the inflation expectations story. This story combined with “It is clear that many people just don’t believe the official numbers.”, gives us a compelling justification for relative price inflation being such a persistent consumer concern. It also tells us very little about the potential impact of “true” inflation, whatever that is.
http://www.clevelandfed.org/research/commentary/2010/2010-17.cfm
One questionnaire I saw mentioned (by Krugman, I think) gave plausible explanation for downward wage rigidity: one expert decided to simply ask owners and managers about downward wage rigidity in crises. The prevailing answer was: “we do everything possible to avoid lowering wages, because lowering wages really, really hurts morale of the workers.”
This seems logical to me, and it comes from the people who actually set the wages.
@Davor That sounds like a survey by Truman Bewely ( a very famous theorist). I think basically all managers say they are concerned about harming morale. Economists have dozens of theories of wage rigidity, but that is the theory which people who actually set wages mention most.
http://economistsview.typepad.com/economistsview/2014/07/links-for-7-21-14.html