Why Central Bankers are Like Sheepdogs

Central bankers and economic policy makers often talk about ‘anchoring expectations’.  What do they mean by that?  The narrative of anchored expectations is difficult to square with modern New Keynesian (NK) theory. The problem with NK theory is that expectations are supposed to be forward looking and rational. And although nobody would deny that central bank announcements do move markets, it is difficult to believe that expectations are forward looking and rational in quite the way that the modern theory of rational expectations requires them to be. Expectations, like sheep, have a life of their own. And like sheep dogs herding sheep, central banks must herd expectations.

In modern NK Dynamic Stochastic Dynamic General Equilibrium Models, (DSGE), expectations are anchored by the so-called rational expectations (RE) assumption. According to that assumption, people today make guesses about what people tomorrow will do. And these people make still further guesses about the actions of other people in the even more distant future. These guesses, so the NK story goes, must be right on average. That of course is poppycock, akin to medieval religious debates about how many angels can dance on the head of a pin.

The problem with the RE assumption, is that there is no obvious right way to guess what will happen in the future. Not only is the future unknown and unknowable; but even in the equilibrium models that NK economists favor, there are many possible rational outcomes each of which would lead to a different expectation today. And each of these expectations would turn out to be rational if only our descendants would  behave in the way we conjecture that they might. As I explained, beginning with my 1993 graduate textbook The Macroeconomics of Self-Fulfilling Prophecies, the existence of multiple equilibria in RE models need not be a 'problem'; it is an opportunity.

NK theorists have tried to tackle the ‘problem’ of multiple equilibria by ruling out some of the possible outcomes in their models by appealing to purely logical arguments. Those attempts to refine equilibria using logic can lead to some pretty absurd conclusions. For example, NK models predict that a fiscal expansion will have a bigger effect on current employment if  it occurs in ten years time, after interest rate policy has normalized, than if it occurs today. Better still, postpone it until the next moon landing. Don’t laugh too hard: it is arguments like these that persuaded otherwise sensible central bankers to use so called ‘forward guidance’.

According to the NK DSGE model, we  all make sensible guesses about what we think the Treasury and the Central Bank will do in the distant future and we alter our existing plans accordingly. In a particularly bizarre manifestation of this theory called the Fiscal Theory of the Price Level (FTPL), we are all supposed to act in a way that causes the current value of government debt to magically equal the value of planned future deficits. For example, if the Obama administration were to announce a new unfunded entitlement, the price level today would increase immediately to reduce the real value of existing Treasury debt. I am not making this up: the FTPL was the content of the warmly accepted lunchtime speech by Nobel Laureate Christopher Sims at the 2016 Jackson Hole conference.

It is not enough, of course, to laugh at the absurdities of existing theories. It takes a model to beat a model. And I have an alternative that  makes a lot more sense. Expectations are not irrational: they are fundamental. What we believe influences what happens. One way to implement this idea is to assume that beliefs about future nominal income growth are equal to current nominal income growth (see here). When that assumption is combined with the Keynesian insight that there are many possible equilibrium unemployment rates, we arrive at a more plausible description of why monetary policy matters than the unlikely fairy tales that are told to justify the broken NK paradigm.

Expectations are like sheep. They must be herded by central bank actions that alter current economic conditions. And like sheep, expectations are stubborn and persistent. Weaving that idea into a consistent macroeconomic narrative leads to a very different prescription for how we should conduct future policy.  The NK model which guides existing macroeconomic policy cannot simply be tweaked as some have claimed. It must be torn up and reconstructed from scratch. That is what I offer in my book Prosperity for All that is now available from a bookseller near you. Also now available on Amazon kindle.