MNI INTERVIEW: Central Banks Underestimate Sticky Expectations

Monetary policymakers have underestimated how changes in inflation have left long-term marks on households’ expectations, leaving them surprised when their measures prove ineffective, a senior advisor to the German government and expert on behavioural economics told MNI, adding that central bankers’ decisions are also measurably influenced by their lifetime memories.

Ulrike Malmendier said she was surprised by the results of her own research which showed how strongly central bankers on the Federal Reserve’s Federal Open Market Committee are steered by their personal experience of inflation.

“When you look at them making forecasts in their semi-annual policy reports to Congress, you can really trace out what inflation experiences they have made personally,” Malmendier, Professor of Economics and Finance at UC Berkeley and a member of the German Council of Economic Experts said in an interview. “Those who have lived through hyperinflation, like the famous case of German-born governor Henry Wallich, or just high inflation, like the 1970s oil price shocks, then they remain rather pessimistic going forward for quite a while. The effect is statistically significant.”

Data from the U.S. and Europe indicate that average lifetime experiences have strong predictive power when individuals assess price rises for the next year or more, said Malmendier, adding that underestimating the extent to which households’ expectations become embedded has led central bankers to overestimate the power of some of their monetary policy making.

“We've often found that some of these monetary policy tools, in particular unconventional tools revolving around announcements, might in fact not be as powerful as one might have expected,” Malmendier said. “I would link that back to the reality of experienced inflation having such a strong influence on expectations and household behaviour over one, two years.”

LOWER EARNERS MORE PESSIMISTIC

Households persistently overestimate the path of inflation, with those on lower incomes more likely to be pessimistic about the outlook, she said. Those most exposed to volatility in the price of food, fuel and energy are also more prone to remember upswings rather than downswings in prices. (See MNI INTERVIEW: Models Of Inflation Expectations Need Refining)

Similarly, younger people used to prolonged low inflation took longer to come to terms with today’s spike in prices than those a generation or two above them, she added - a factor that could influence the degree to which they are prepared to borrow and spend.

Central banks should look more closely at broader-based inflation surveys, and give less emphasis to surveys of professional forecasters when considering policy, said Malmendier, adding that the current jump in inflation could inflict long-term scarring on expectations unless a slowdown in price increases is made “viscerally, experientially clear” to households.

“I'm not too optimistic yet that we have found a way to generate these effects,” she said. “I would be pushing more towards simple communication that relates to lived reality.”

Malmendier, who joined the GCEE advising chancellor Olaf Scholz on fiscal policy in September last year, said the Council is now much more data-driven and less given to accept opinion without evidence than previously.

“Behavioural economics is certainly gaining interest among politicians and central bankers. So when politicians ask me what I think about an issue, and I can talk about peer effects, default effects, and nudges, I think it’s wonderful that evidence-based behavioural economics isn’t being left out of the toolbox anymore.”