Inflation will be exactly what people think it will be

As central banks rely more on market expectations to orchestrate macroeconomic outcomes, the views of Fischer Black on inflation don't seem far from the current mainstream.

Pedestrians pass a sale sign outside a clothing store in Hauz Khas Village in New Delhi | Photo: Prashanth Vishwanathan | Bloomberg

Sometimes yesterday’s crazy idea turns out to be sane or even essential. For instance, Fischer Black, the late finance economist and co-discoverer of modern options pricing theory, argued that the rate of price inflation will be whatever we think it will be.

If expectations are that inflation will be high, it will be high. If expectations are that inflation will be low, it will be low. For Black, who died in 1995, this was always true, at least for modern economies.

I never agreed with Black on this point, but increasingly I have begun to wonder if he wasn’t on to something. Plenty of people like to say that they knew at the time that the big money supply increases of 2008-2009 were not going to lead to high inflation. There are also people who like to say that they knew at the time that the combined monetary and fiscal response from the pandemic would lead to much higher rates of price inflation. But relatively few people can gloat about getting it right both times.

In Black’s view of the world, if people expected inflation to be high, they would spend and borrow more. Banks would create the money for this process to be self-sustaining. Under this framework, Black might have argued that no major inflation resulted after 2008 because Americans simply were not bullish enough, given the recent financial trauma.

Paul Krugman has argued that there was not high inflation after 2008 because the U.S. economy was in a liquidity trap. Black’s rejoinder to the Keynesians was a subtle one: We are always in a liquidity trap. Since banks can bid for reserves, and reserves can pass in and out of banks freely, the net value of additional bank reserves must be equal to other uses of the funds. The monetary expansion of the U.S. Federal Reserve, which operates through banks, is thus like swapping two nickels for a dime. Whether or not nominal interest rates are zero, after the swap banks can still move back to whichever portfolio they wished to hold. Thus any Fed actions will prove neutral if that is what the banks, and the economy as a whole, desire.

One argument is that it is different this time because the U.S. government engineered a major fiscal policy response to the crisis, not just a monetary response. Maybe, but if you focus on the fiscal side, you should be very strongly on Team Transitory — that is, believe that currently high inflation rates will fade rapidly. The fiscal response now lies firmly in the past, and so the inflationary pressures should be subsiding.

I can’t say that view has been refuted — who knows what next month may bring? — but it is looking less likely. If anything, the data are showing the inflationary pressures being transmitted to more sectors of the economy.

The reality is that the U.S. economy, along with many others, saw a recovery of surprising speed and strength in 2021. That produced a lot of optimism, which mostly has persisted, even in light of delta and omicron. In the Black view, that optimism produces a lot of spending and borrowing. Nominal variables will explode accordingly, and indeed they did.

Have you ever wondered why a country such as South Korea had inflation as high as 19% during its high-growth years? In general, high-growth countries often have high inflation.  Those results make sense in the Fischer Black worldview.

So if Black was right, what does this mean looking forward?

Market expectations for inflation have recently turned up sharply for the one-year horizon, and for the three-year time horizon they still stand above 3%. Black did not argue that such expectations had to be stable, but that they may be the best guess for where we are headed. Another idea that is suspect is the notion that the Fed can steer the rate of price inflation as it chooses.

I can’t quite bring myself around to the Fischer Black view on inflation. I was brought up believing in a well-defined quantity of money that causally determines the price level, and I still see central banks commanding a lot of attention from the markets. Nonetheless, as central banks rely more on market expectations to orchestrate macroeconomic outcomes, I no longer see the Fischer Black views as so far from the current mainstream.

I am reminded of Hamlet’s words to Horatio. If the world as a whole is getting weirder, and it seems to be, then maybe inflation is, too.- Bloomberg