Streetwise for Sunday, October 17, 2021

This week’s column is unlike any I have written in the past almost 34 years that I have been a newspaper columnist. Moreover, this is a column I am quite proud to write.

The subject deals with the issue of the degree of influence has on the rate of inflation. Specifically, to what extent do inflation expectations on the part of consumers influence the resulting rate. Or as the New York Times explained, a central tenet of mainstream economic theory is that public fears of inflation tend to be self-fulfilling.

Specifically, a paper on the subject was written by my son Jeremy Rudd, a senior adviser at the Federal Reserve in Washington, D.C. The 27-page tome, published as part of the Fed's Finance and Economics Discussion Series, has become, according to the New York Times, a viral sensation among economists.

As the Times points out, the paper disputes the idea that people's expectations for future inflation matter much for the level of inflation experienced today. That is especially important right now, in trying to figure out whether the current inflation surge is temporary or not.

However, as the Times points out, Jeremy’s work is part of something larger. It reflects a broader rethinking of core ideas about how the economy works and how policymakers, especially at central banks, try to manage things. This shift also includes debates regarding the relationship between unemployment and inflation and how deficit spending affects the economy.

In effect, many of the key ideas underlying economic policy during the Great Moderation - the period of relatively steady growth and low inflation from the mid-1980s to 2007, increasingly look to be at best incomplete, and at worst wrong.

It is vivid evidence that macroeconomics, despite the thousands of highly intelligent people over centuries who have tried to figure it out, remains, to an uncomfortable degree, a black box.

The Times points out that millions of people bounce off one another - buying and selling, lending, and borrowing, intersecting with governments and central banks, along with businesses in a manner that is so complex it becomes incomprehensible.

According to Brian Romanchuk's commentary in "Bond Economics", the strength of Jeremy’s article is its survey of empirical works on inflation expectations (many of which featured Jeremy as an author), while he was not familiar with most of the cited empirical papers his bias is to agree with the premise that the empirical basis for neoclassical beliefs about inflation expectations is somewhat shaky.

Now, despite Jeremy being my son, I would be remiss if I did not point out that the paper and its premises did not meet with universal approval or agreement.

James Freeman comments in the Wall Street Journal were that the paper is ostensibly a challenge to conventional views on inflation expectations.

Is that not what research is supposed to accomplish, the development of new ideas and ways forward?

Specifically, Freeman’s claim is that according to Jeremy, economists and economic policymakers believe that households' and firms' expectations of future inflation are a key determinant of actual inflation.

However, a review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.

What seems to have disturbed Freeman the most was Jeremy’s statements that mainstream economics is replete with ideas that "everyone knows" to be true, but that are arrant nonsense...

No doubt, one reason why this situation arises is because the economy is a complicated system that is inherently difficult to understand... Is this situation ever harmful or dangerous? One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions.

Given my bias, intentional or not, regarding my respect for Jeremy’s extensive quantitative and research skills, my candid observation is that Jeremy’s paper, which I have read in detail, has significant merit, and speaks to the need for additional discussion and research.

Lauren Rudd is a Managing Director with Raymond James & Associates, Inc., member NYSE/SIPC. Contact him at 941-706-3449 or Lauren.Rudd@RaymondJames.com. All opinions are solely those of the author. This material is provided for informational purposes only, is not a recommendation and should not be relied on for investment decisions. Investing involves risk and you may incur a loss regardless of strategy selected. Past performance is no guarantee of future results.