Inflation can become a self-fulfilling prophecy |
Managing inflation expectations will be a key challenge in the coming year, says Daniel Mahoney
When does a prophecy become a reality? Since the 1970s, it has been conventional wisdom that the key to controlling inflation is controlling inflation expectations – but outside economics circles it is not often appreciated why. However, managing expectations increasingly looks like a key challenge for the coming year. So why must they be managed, and what does this mean in practice?
For the last half century most economists have agreed monetary policy is best run according to strict rules, rather than by giving central banks unlimited discretion to react to events. A number of different rules were tried between the 1970s and 1990s – incomes policy, money targets, exchange rates targets – but from the 90s, inflation targeting became the main aim of much of the western world. Central banks have aimed for low, stable inflation, typically of around 2 percent. This level allows businesses and consumers alike to plan for the future. Central banks dislike deflation, which creates difficulties owing to the ”money illusion”, whereby people focus on the face value of money rather than its purchasing power. This means they won’t accept wage reductions,........