It’s a frequent source of irritation to me that people don’t take Rutherford’s famous wisecrack more seriously: “All science is either physics or stamp-collecting”. Spoiler: economics is not physics. It will never be physics. It will always be a science of human behavior. Not quite stamp-collecting but closer to it than it is to physics. When I was in grad school econometrics, the use of mathematics, particularly statistics, in economics was just gaining steam. Those who entered the field in that period who have little interest in observing human behavior or are incapable of observing human behavior, cannot quite forgive economics for not being physics.
Those are the underpinnings of Tyler Cowen’s post at Bloomberg in which he draws attention to the psychological component of inflation:
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.
concluding:
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.
If people believe that tomorrow’s prices will be higher than today’s and they have the money to do it, they will buy today rather than spend more tomorrow. If in addition people believe that should they run out of money that a generous federal government will give them more, why not buy today?
Believing that the Fed can control inflation while not being led to believe that there’s always more money where that last windfall came from may be important components of restraining inflation. I’m not confident that the people in place to do those things have the cojones to do them.
I don’t think people understand the difference between inflation, and price increases of certain products and services due to production issues and consumer choices.
Fischer Black was simply flat damned wrong, despite his fabulous work in developing the Balck-Scholes-Merton model.
“Believing that the Fed can control inflation while not being led to believe that there’s always more money where that last windfall came from may be important components of restraining inflation.”
The Fed absolutely can. But they can’t control the bastardization (reduction) of beta, which would throttle the price escalation of risk assets. For thousands of years: risk vs reward. Does anyone have the balls? We will find out the relative preferences of politicians on recession vs inflation soon.