Expectations, inflation, and asset bubbles

Mahmoud Mohieldin
Tuesday 11 Jan 2022

Developing countries need to continue to combat inflation this year by pursuing an effective inflation-targeting framework while sustaining high inclusive growth and employment objectives, writes Mahmoud Mohieldin

If “judgement is a matter of perception,” as they say, then perception is constrained by the available information and by the ability to analyse and process it rationally. 

In sociopolitical phenomena such as the economy it is hard to separate the object of analysis from the political or ideological biases of the analyst and, indeed, from his or her personal hopes and wishes. Forecasts and expectations can also play a part in shaping economic trends, one example of which can be seen in the way that expectations can impact inflation. 

One school of economists holds that the expectations of ordinary people from consumers to investors are the chief determinant of changes in prices. This means that price fluctuations are contingent on psychological factors that are difficult to quantify or to predict. Proponents of this view agree with mainstream view that if the supply of money significantly exceeds the supply of goods and services, prices will tend to go up. If people think that money supply will increase such that more money is chasing fewer goods, their predictions of how this will affect prices will change their economic behaviour. 

In other words, according to this school of thought, if people anticipate inflation, then inflation will happen because people’s expectations will have caused it.

One of the most influential economists in the world is the US economist Robert Lucas, known for his contributions to developing models building on the assumptions of rational expectations. He was awarded the Nobel Prize in Economics in 1995 for work which was “part of an effort to understand how changes in the conduct of monetary policy can influence inflation, employment and production,” as reflected in the announcement of the Nobel Prize committee at the time. 

One is reminded of a quotation often attributed to US baseball player Yogi Berra that is often cited in academic circles, namely that “in theory there is no difference between theory and practice. In practice there is.” Regardless of the controversy over the viability of rational expectations theory, the type of information it requires and the rationality of its conclusions, expectations about inflation and its impacts on future trends are vital to the operations of central banks and their monetary policies.

In the US and Europe, inflation rates have gone well beyond their two per cent target to reach almost seven per cent in the US and over five per cent in the EU. For the US, these are the highest rates in 40 years, while the EU has seen nothing like them since the euro was introduced two decades ago. 

As a means to curb inflation, the major central banks try to minimise expectations of price increases by offering assurances that they will do everything in their power to prevent inflation rates from climbing and that they have the monetary policy tools to do this, including raising or lowering interest rates or intervening in the market to buy or sell financial assets. 

I will focus mostly on inflation in the US in this article, not only because it is the largest economy in the world, so far, but also because of the influence of the dollar as a reserve currency and an international currency for trade and investment. 

In 2021, the dollar still made up 60 per cent of international reserves (down from 71 per cent in 2000) compared to 21 per cent for the euro, six per cent for the yen, five per cent for sterling and two per cent for the Chinese renminbi. Most of the dollar reserves of the countries that have them is in the form of US treasury instruments. Investors and individuals around the world hold about $950 billion or roughly 50 per cent of the total US banknotes. The dollar is still used to settle accounts in 95 per cent of trade transactions in the Americas, 74 per cent in Asia and 79 per cent in the rest of the world, apart from Europe where the euro dominates. About 60 per cent of the international debt market is in dollars compared to only 23 per cent in euros. 

Some believe that the US Federal Reserve was overly optimistic when it predicted that the current inflation would be temporary, despite signs to the contrary due to production and distribution blockages preventing supply from keeping pace with large surges in demand. Some economists argued that one of the justifications for this optimism was the need to influence expectations in order to keep them from producing higher rates of inflation than the economic situation warranted. 

When asked whether inflation in the US would return to its two per cent target by the end of 2022, chief economics commentator at the London Financial Times Martin Wolf said that it would not and that it was a mistake to describe the inflation the US was experiencing as temporary. Despite the likelihood that shortages in goods and services will lessen over the course of the year, the pressures on the labour market will increase wages while real interest rates are negative, making it more likely that the core inflation index will go up rather than down.

I believe that fighting the ongoing and growing inflation will take priority over fighting unemployment in economic policymaking in the developed countries this year. In the US, in addition to reversing monetary easing measures, there are signs that the Federal Reserve will raise interest rates several times by a quarter of a point, bringing it to 1.75 to two per cent during the coming 24 months and up from its current level of 0.25 per cent since March 2020. 

These increases might seem minor, but their impact on reducing inflation will be significant if they are accompanied by a continuity that strengthens confidence in the direction the Federal Reserve has taken. However, their impact on the so-called bubbles experienced in the money markets, in real estate and gold prices, and in the crypto-currency markets will be greater. Some might see this as major market corrections, while others might see it as the beginning of another season of bursting assets bubbles whose prices have soared above their fair value and economic benefits. 

This will bring fluctuations in the financial markets and in capital flows directed to the emerging markets and developing countries, with all the consequences that this entails. 

In the light of the foregoing, the developing nations need to continue to combat inflation by developing an effective inflation-targeting framework along the lines I described in a contribution to the Encyclopedia of Arab Knowledge for Sustainable Development produced by the Arab Academy of Sciences in collaboration with UNESCO in 2006. 

The framework consists of six points:

- Publishing inflation targets for the short and medium terms;

- A strict institutional commitment to price stability as an overall economic and not just a monetary policy objective; 

- Developing a comprehensive information policy covering how information is shared, circulated and protected; 

- Applying the principles of transparency and adequate disclosure in the implementation of monetary policy and improving effective communication with the public and with others concerned;

- Granting central banks sufficient legal and practical tools to achieve the objectives of monetary and financial stability and guaranteeing their independence in conducting these tools.

- Using inflation-targeting framework as a basis for coordinating monetary and fiscal policies and assessing their performance.

In addition to combatting inflation, the developing countries need to sustain high growth and employment rates in order to fight poverty and income disparities. At the same time, however, they must avoid falling into a debt trap. 

The development remedy for these problems relies on investing in human capital, infrastructure and technology, and in society’s capacities to address climate change and to manage the necessary adaptation and mitigation processes in a manner consistent with achieving the sustainable development goals. 

 * An Arabic version of this article appeared on Wednesday in Asharq Al-Awsat.

*A version of this article appears in print in the 13 January, 2022 edition of Al-Ahram Weekly.

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