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Warren Buffett once famously said forecasts tells us a great deal about the forecaster, they tell us nothing about the future. And following the South African Reserve Bank’s decision to hold rates last week, well-known economist Brian Kantor applies his mind to the concept of inflation expectations, and how this sense of control impacts future decision-making, such as interest rate hikes or cuts. Kantor says that in this quest, Central Bankers are perhaps promising more than they can hope to deliver, and so putting the limelight on themselves. He calls for more Central Bank modesty, and realism, as to what they can and cannot do. A must read. – Stuart Lowman
By Brian Kantor*
Tim Harford of the Financial Times in an article carried in Business Day 18th May (Big data power up inflation figures) writes of the attempts under way to predict inflation ahead of the official data releases using ‘big data” – in this case observing continuously thousands even billions of prices reported online “by hundreds of retailers in more than 60 countries”
There is however more to this very welcome exercise made possible by modern technology than improving our measures of inflation – or being better able to adjust prices for changes in the quality of the goods and service being priced in the market place – a truly formidable task as Harford suggests. Or for that matter in the practice of in using high frequency data to predict the next GDP announcement, which also comes with something of a time lag. Helping to anticipate the next GDP announcement in the US is an exercise undertaken by one of the branches of the Fed. The Federal Reserve Bank of Atlanta publishes its GDPNow forecasts of GDP that are attracting understandable attention in financial markets.
The primary purpose in being able to more accurately predicting inflation or growth announcements to come is that it helps the forecaster to anticipate central bank policy changes – in the form of interest rate adjustments or doses of money creation – now called Quantitative Easing- that may follow the news about inflation or growth. Past performance tells us that central banks will react in predictable ways to the unexpected, to the surprisingly good or bad economic news to which inflation and GDP announcements make a large contribution. The economic news is important because the central bank regards the news as important. They are mandated to meet targets for price stability and to help the economy realise its growth potential. Knowing what the central bank will do can be very valuable information. Valuable because what central banks can do is move markets. And beating the market – being ahead of the market moves – can be extraordinarily valuable. Just as being behind the new direction of a market can be as damaging to participants in markets who miss-read the signals.
Central banks however can only move the markets in what they may regard as the right directions if they can take the market place by surprise. As is well recognized in the market place – only surprising news matters – the expected is captured in current prices and valuations. And so there is every reason for participants in the financial markets not to be surprised so that they can take evasive action in good time and position themselves for what central banks and the market may do to them. Better forecasting models of inflation or growth – or even of the next inflation or GDP announcements, using new technology – big data – helps market participants to realize profits or avoid losses.
#MyDepressionLooksLike Uncontrolled inflation, elevated unemployment rates, and slow economic growth.
— Lee Valentine (@LVOTUS) May 22, 2016
Yet by anticipating central bank action the market place helps void the intended influence of central bank actions on the economy. This makes central banks much less influential over the economy than the still generally accepted conventions allow central bankers about the role they can and should play in managing the business cycle. Robert Lucas of Chicago in 1995 was awarded a Nobel Prize in economics (as were other rational expectation theorists, for this “policy invariance” critique of central banks, including Finn Kydland and Edward Prescott (2004). And one could add to this list of path breaking Nobel Prize winning economists, Edmund Phelps (2006) and even Milton Friedman (1976) honoured for demonstrating that economic growth could not be stimulated by inflation. They showed that any favourable trade-offs of inflation (bad) for more growth (good) were between unexpected inflation (not inflation) and GDP growth – something very difficult to achieve in any consistent way because of inflation avoiding behaviour market participants would be bound to take.
The case for more inflation had been made by the famous Phillips curve – a theory that at one stage enjoyed wide support in the economics profession as a justification for engineering more inflation. Inflation (higher prices) it was thought could help overcome price and wage rigidities that were presumed to prevent an economy finding its own path to full employment. It became the essence of Keynesian economics.
Modern central bankers now take inflationary expectations very seriously. So labelled Expected inflation augmented Phillips curves are at the heart of their inflation modelling. (Inappropriately given the history of a failed theory) They attempt through their policy interventions to “anchor” inflationary expectations – as the phrase goes. By anchoring inflationary expectations they hope to avoid inflationary surprises that are well understood to be damaging to the real economy.
Unexpectedly high or low inflation makes it harder for firms and trade unions, with price and wage setting power to make the right output and employment optimizing decisions about wages and prices. Unexpectedly high or low inflation can temporarily confuse them about the true state of the economy and so exaggerate the direction of the business cycle that will in time be reversed as inflation expected adjusts to actual inflation.
But this sensible understanding of the need to avoid inflation surprises does not seem to inhibit the larger ambitions of central banks to manage the business cycle. They still seem to believe that they able to helpfully “fine tune” the economy – manage the business cycle – through appropriate changes in interest rates and QE so that the economy can realize its full growth potential. But logically or rather illogically this must mean being able to surprise the market place with their policy reactions – a market that is very determined not to be surprised.
More Volcker: Should the Fed's objective be price stability, or hitting 2% inflation? pic.twitter.com/KpKdRin75G
— Information Overflow (@InfrmtnOverflow) May 22, 2016
In pursuing such grand ambitions to manage more than inflationary expectations, central bankers are perhaps promising more than they can hope to deliver – and so attaching too much attention to themselves. The market place has become increasingly skeptical about central bank delivering on its promises to manage aggregate global spending, demand that remains deficient despite the best efforts of central bankers world-wide. More central bank modesty – as well as more realism in the market place – about what central bankers can and cannot do – is called for.
- Brian Kantor is chief economist and strategist at Investec Wealth & Investment. The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment.
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