Another issue is how to find the right variables to predict future inflation. Economists often use the Phillips curve relationship, with inflation depending inversely on unemployment—that is, lower unemployment puts upward pressure on wages and, eventually, on inflation. But while an unemployment rate variable is common, it isn’t clear that this is the best gauge. Stock and Watson (1999) and Wright (2009) consider a broader range of possible “economic slack” variables and then use different ways to condense the information in these variables to predict future inflation. Generally, these approaches do as well as or better than autoregressive models. Atkeson and Ohanian (2001), however, conduct a similar exercise but focus on the post-1985 period, which—up to the advent of the Great Recession—was a period typified by remarkably low and stable inflation in the United States. Using the Chicago Fed National Activity Index (CFNAI), which summarizes information across many activity variables, they show that the resulting inflation forecasts are worse than when one just relies on current inflation to forecast future inflation.
Links omitted. Pointer from Mark Thoma.
Standard macro theory includes a “tight” model of inflation. You might have a Phillips Curve in which inflation depends on unemployment. Or you might prefer a monetarist formulation, in which inflation depends on money growth.
However, if you rely on these relationships in the real world, your predictions for inflation will be awful. Think of your forecast as a weighted average of
a) inflation tomorrow will be what it was yesterday; and
b) inflation tomorrow will be determined by measures of economic slack and/or money growth
If you put any significant weight on (b), you will be hosed.
My own inclination, which I think is close to that of the late Fischer Black, is to treat both money and the average level of prices as consensual hallucinations. As far as money goes, we accept currency and abstractions representing currency today because we expect that other people will accept them tomorrow. The prices that we charge today are based on prices that we expect to face tomorrow. These habits and beliefs are extremely sticky, and they are usually self-validating.
Let me put it this way:
the average behavior of prices is an emergent phenomenon, not a phenomenon that is controlled top-down through the manipulations of the central bank.
Read that several times, until you appreciate the heresy.
I do subscribe to a fiscal theory of hyperinflation. If the government runs deficits and loses the ability to fund those deficits with long-term borrowing, then it has to go on a money-printing frenzy that will destroy the emergent properties of money and prices.
Along those lines, I am curious as to what will happen in Japan. The fiscal and monetary authorities there would like to engineer a moderate level of inflation. What they seem to be doing strikes me as sufficient to generate hyperinflation. So far, a consensual hallucination of zero inflation seems to be holding.
I think that economists should be very modest and humble in claiming to understand inflation.
I prefer tautology. Inflation is when money is a liability. Deflation is when money is an asset. Zero is when money is a store of value. The circumstances under which any of these states occur will vary.
If by emergent you mean people and the central bank are double ( and triple and quadruple) guessing each other as to what each will do under any circumstance and reacting accordingly, then yes, jointly co-determined.
Or as central banks have inflation fighting credibility, producers won’t expect they will be able to raise prices or offer much more for wages, so low unemployment won’t readily lead to inflation, and only if they allow very low unemployment for a considerable time without reacting will that begin to change. Frozen in low inflation, much heat must be applied for thawing for the temperature to rise at all and once it does it will be as subject to refreezing as warming. About the only way sovereigns lose access to funding is to default and even that is temporary and they always have the option to restore fiscal order as long as borrowing in their own currency, so inflation is a choice. It is hard enough believing a bank that has operated at 0 for more than a decade will allow 2 even as they say, they would have to become entirely subservient to fiscal authorities to allow more. That requires a revolution in governance.
Agree with your final conclusion – my suspicion as you indicate is that the money/price belief system is indeed very sticky, until it’s not, and then big changes can occur fast. But what kinds of things lead to such tipping points is very unclear.
I liked John Kay’s line: “prices are the product of a clash between competing narratives about the world” (http://ineteconomics.org/blog/inet/john-kay-map-not-territory-essay-state-economics) – so what makes one narrative finally dominant?