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.

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