On inflation targeting and rational expectations

6 Feb, 2013 at 17:50 | Posted in Economics | 4 Comments


The Riksbank in 1993 announced an official target for CPI inflation of 2 percent. Over the last 15 years, average CPI inflation has equaled 1.4 percent and has thus fallen short of the target by 0.6 percentage points. Has this undershooting of the inflation target had any costs in terms of higher average unemployment? This depends on whether the long-run Phillips curve in Sweden is vertical or not. During the last 15 years, inflation expectations in Sweden have become anchored to the inflation target in the sense that average inflation expectations have been close to the target. The inflation target has thus become credible. If inflation expectations are anchored to the target also when average inflation deviates from the target, the long-run Phillips curve is no longer vertical but downward-sloping. Then average inflation below the credible target means that average unemployment is higher than the rationalexpectations steady-state (RESS) unemployment rate. The data indicate that the average unemployment rate has been 0.8 percentage points higher than the RESS rate over the last 15 years. This is a large unemployment cost of undershooting the inflation target. Some simple robustness tests indicate that the estimate of the unemployment cost is rather robust, but the estimate is preliminary and further scrutiny is needed to assess its robustness.

During 1997-2011, average CPI inflation has fallen short of the inflation target of 2 percent by 0.6 percentage points. But average inflation expectations according to the TNS Sifo Prospera survey have been close to the target. Thus, average inflation expectations have been anchored to the target and the target has become credible. If average inflation expectations are anchored to the target when average inflation differ from the target, the long-run Phillips curve is not vertical. Then lower average inflation means higher average unemployment. The data indicate that average inflation below target has been associated with average unemployment being 0.8 percentage points higher over the last 15 years than would have been the case if average inflation had been equal to the target. This is a large unemployment cost of average inflation below a credible target. Some simple robustness tests indicate that the estimate of the unemployment cost is rather robust, but the estimate is preliminary and further scrutiny is needed to assess its robustness.

The difference between average inflation and average inflation expectations and the apparent existence of a downward-sloping long-run Phillips curve raises several urgent questions that I believe need to be addressed. Why have average inflation expectations exceeded average inflation for 15 years? Why has average inflation fallen below the target for 15 years? Could average inflation have fallen below average inflation expectations and the inflation target without the large unemployment cost estimated here? Could the large unemployment cost have been avoided with a different monetary policy? What are the policy implications for the future? Do these findings make price-level targeting or the targeting of average inflation over a longer period relatively more attractive, since they would better ensure that average inflation over longer periods equals the target?

Lars E.O. Svensson, The Possible Unemployment Cost of Average Inflation below a Credible Target

According to Lars E. O. Svensson  – deputy governor of the Riksbank – the Swedish Riksbank has been pursuing a policy during the years 1998-2011 that in reality has made inflation on average 0.6 percentage units lower than the goal set by the Riksbank. The Phillips Curve he estimates shows that unemployment as a result of this overly “austere” inflation level has been almost 1% higher than if one had stuck to the set inflation goal of 2%.

What Svensson is saying, without so many words, is that the Swedish Fed for no reason at all has made people unemployed. As a consequence of a faulty monetary policy the unemployment is considerably higher than it would have been if the Swedish Fed had done its job adequately.

From a more methodological point of view it is of course also interesting to consider the use made of the rational expectations hypothesis in these model-based calculations (and models of the same ilk that abounds in “modern” macroeconmics). When data tells us that “average inflation expectations exceeded average inflation for 15 years” – wouldn’t it be high time to put the REH where it belongs – in the dustbin of history!

To me Svensson’s paper basically confirms what I wrote a couple of months ago:

Models based on REH impute beliefs to the agents that is not based on any real informational considerations, but simply stipulated to make the models mathematically-statistically tractable.

Of course you can make assumptions based on tractability, but then you do also have to take into account the necessary trade-off in terms of the ability to make relevant and valid statements on the intended target system.

Mathematical tractability cannot be the ultimate arbiter in science when it comes to modeling real world target systems. Of course, one could perhaps accept REH if it had produced lots of verified predictions and good explanations. But it has done nothing of the kind. Therefore the burden of proof is on those who still want to use models built on ridiculously unreal assumptions – models devoid of all empirical interest.

In reality, REH is a rather harmful modeling assumption, since it contributes to perpetuating the ongoing transformation of economics into a kind of science-fiction-economics. If economics is to guide us, help us make forecasts, explain or better understand real world phenomena, it is in fact next to worthless.


  1. I do believe that a low real exchange rate is good for employment. So no matter what inflation rate you have, if you have a high real exchange rate you will have high unemployment.

    The only way to get a low unemployment is too intervene in the currency market and actively lower the nominal exchange rate of the Swedish Crown. And to do that does not require as much as one penny in foreign reserves. I am thinking of a US dollar well above 10 crowns.

    And in order to avoid an inflation bringing the real exchange rate back to its previous and too high level, the RIksbank ought to drastically raise official lending rates. Borrowers should not be able to borrow cheaply from the Riksbank but at high interest rates on the international money market. If the exchange rate is fixed in terms of dollars, the world market for dollar loans would be open for borrowers, but there would be no cheap loans from the Riksbank.

    This would accomplish a lower and more employment-friendly exchange rate and also prevent an inflation which would make the real exchange rate return to its previous too high level. I believe that practically speaking full employment could be accomplished in less than 18 months.

    And it is no problem at all to fix the exchange rate below its equilibrium point, the problem is when you try to fix it above its equilibrium point. In that case you have to sell off foreign reserves and ultimately you might run out of reserves and be forced to give up your attempt to maintain an overvalued exchange rate.

  2. Hello Professor ,

    Sorry for my awful english,

    Im a french doctoral student,

    Im still working on Alfred Schutz’s sociology for wich i was asserting that it provided the very theory of dialectic as a circular movement or a double movement process (similar to Marx’s critical dialectic or Adorno’s negative dialetic): this is the very theory of critical feature of dialectics wich will leads us to define the concept of ideology.

    Alfred Schutz is an austrian sociologist who nourished very deeply Hayek’s political economy (also Mises and so forth).

    It is paramount to coin this Schutz’s circular retroactive movement of the dialectical process for understanding the phenomena of monetary illusion, commodity fetichism, fictitious capital or “forced saving ” doctrine.

    Hayek considered that workers are victims of monetary illusions although they are very aware that general level of price is relevant but they are forced to believe in nominal wages.

    “nominal wages” is no less real than “real wages” but Hayek consider that workers endorsed the capitalist standpoint and this is why they are victims of monetary illusions.

    The nominal refers to the spatio temporal sphere or the dominant reality where the real designs the dominated reality but both are real.

    This is the same for business cycle theory where effective rate of interest defines the dominant reality and the natural rate of interest means the dominated reality .

    Forced save doctrine is the result of the monetary illusion of the capitalist when the effective rate is lower than the natural one they are forced to accumulate capital and subsequently forced workers to austerity: the capitalist is very aware that the credit is the illusion of the money but he’s forced to beleive in it.

    Money as an institution is a ruling relation.

    For instance Schutz deeply influenced Hayek’s “economics and knowledge”(1937) where the central thesis is purely schutzian the pure logic choice or tautology “economics” becomes retroactively objective knowledge once it appears in material reality that is to say ideology (abstract and anonymous).

    This is crucial for understanding the double movement of the dialectical process in marxian terms (real and retroactive formal, double feature of value and so forth) hayekian terms ( natural interest rate and effective interest rate, true and false individualism that is to say real and formal individualism) and keynesian terminology( real wages versus nominal wages for instance) and so on.

    I was telling you that the emergence of the “cogito” is the final moment that is to say the “speculative moment” of the constitution process (or the dialectical process) wich will leading to “the sum” only by a “retroactive process”.(Schutz called this retroactive process “the recollection”).

    Once the subjective meaning (symbol intended) emerges from the inner time of duration into the objective spatio temporal time it will be retroactively change into a symbol as an object (symbol posited): this is the very definition of ideology . Zizek illustrated that defintion into a “symbolic object “of ideology although he did not raised the central issue of retroactive bergsonian conception of time endorsed by Schutz.

    In other words, “the sum” is the intellection of the cogito where the effect creates retrospectively its own cause: “cogito” ergo retroactively “sum”.

    Schutz’s phenomenology is paramount in the sense that he combines the phenomenological constitution process with the Bergson’s retroactive conception of time where the real creates retroactively the possible .

    Bergson distinguished the inner time of duration (the death , the passivity , the apathy or the very sartrian nothingness) and the spatio-temporal time of consciousness: consciousness is the speculative moment (spatio-temporal time )of the constitution process wich , retrospectively, re constituted the being.

    Therefore , Schutz would be of great help for the better understanding of Sartre’s assertion that “existence preceeds the essence”: the existence , as the speculative moment (discovery moment) of the constitution process , creates the essence of The being by confering “a sense to the essence of Being”.

    Thus, what Schutz called the “meaningful construction” of the social reality is this circular movement of dialectics where the subjective meaning emerges as a speculative moment of the constitution process within inner time of duration and once it emerges in the spatiotemporal world it retroactively change our experience.

    Therefore the speculative moment of the constitution process once it appears becomes retroactively an analytical life form.

    This is what Adorno’s would call “negative dialectic” or what Marx would called the critical feature of dialectical process that is to say the circular movement ( the double movement).

    Then, such a double movement of the dialectical process , the so called critical dialectical process stressed the double character of commodity as a double character of value and draw our attention the circular movement of reproduction very well described by Marx in “the Capital”.

    Commodity fetichism is the best illustration of this double movement : we are well aware (in the inner time of consciousness) that such a commodity is representing social antagonism but we are “retroactively”(in spatiotemporal world) forced to believe in magical properties of the commodity.

    This is the very definition of ideology: we are very conscious of this illusion but retroactively we are forced to believe in it.

    This may appears to us as a theoretical answer to the paradoxical assertion of the existence of a social class without class consciousness.

    Hayek , grounding its brain theory on Schutz’ analysis of the order as the double movement of dialectic stressed the thesis that we firstly act or behave and once the speculative moment appears then its retroactively change our initial sensation we had till now: the brain theory of the existence of class without class consciousness.

    Such double movement of the dialectical process is a relevant explanation for clearing the dichotomy real and formal : real rights versus formal rights, formal freedom versus real freedom and so forth.

    We are very aware in the inner time of duration (real) that “freedom” , “law” and “democracy” are illusions but we are “retroactively” forced to believe in democracy freedom and law.

    Once freedom law and democracy as a speculative moment then we are retroactively experienced these life forms as abstractions and illusions: this is the critical feature of ideology.

    Formal freedom, formal democracy and formal law are the ideology of freedom, democracy and law.

    The Kelsen’s pure theory of law must be understanding as the ideology of law in the light of what we have said of this double movement of the dialectical process.

    Accordingly, one should reexamine the Popper’s critical realism (or the critical rationalism) in the light of Alfred Schutz’s work.

    The critical feature of science (Popper) have to be subsume by the “feed back effect” of reality.

    The Popper’s situational analysis is proceeding from the schutzian (bergsonian) retroactive conception of time where once the event or the act is completely acheived we are retroactively reconstructing(changing) the causes of the event: this is the very definition of conjectural history as a reconstruction of the historical process from the situational standpoint, the effect creates its own cause.

    The critical feature of science is closely linked to the “retroactive ” effect of “objective reality”: the critical feature of objective knowledge of ideology.

    This is why Popper was reluctant to endorse the concept truth wich supposes the concept of hegelian identity to prefer the notion of verisimilarity or non identity between the concept and the fact resulting from the retroactive effect.

    To conclude i would say that Alfred Schutz critical realism or the circular process of dialectics shares a genuine commonground with Adorno’s negative dialectic.

    Thank you.


    • Hello Professor,
      All my apologies for this awful english,
      Im a french doctoral student,
      Again, Alfred Schutz’s theory of history is central : a new historical context (fact or an event) change retroactively the narrative or the history of facts and ideas.

      This assertion is based on Bergson’s “real and possible” when an event retroactively provokes an open space for new possibilities.
      Neo liberalism is the resurrection of “the liberal ideology” in a new historical context: liberal ideology is a spectrum or a mirage wich is re appears in a new historical context and restructures retroactively all the narrative.
      Hence, the economic theory as an ideology retroactively make its tradition from Hayek to Menger adam Smith and Mandeville.

      Then, Hayek’s spontaneous order theory retroactively creates its own historical tradition: the so called “tradition of spontaneous order”.

      You will see the real goal of such a reinterpretation of liberal tradition wich is aiming to separate “continental” from “anglo-saxon” traditions in order to avoid the regognition of liberal legacy in marxian theory.

      My research about Hayek’s capitalism theory is going further: im proposing to explore the central role of “the narrative of liberal tradition” made by Hayek in the frame of the history of ideas , the so called ” tradition of spontaneous order”.

      The aim of such a narrative or such history of ideas is to normalize Adam Smith as the “foundator” of political economy in order to make the “economic theory ” the ideology of the “bourgeoisie” or “the oligarchy” ruling class.

      In this regard, there is a strong commonground with 19th century capitalism where “manchester school” proceed to a normalization of Adam Smith where economic theory serves as the ideology for the dominant ruling class.

      This alliance between capitalists and economists is central to understand the 19th capitalism and also 20th century capitalism and the importance of think tanks (Mont pelerin society, institute for economic affairs and so forth).

      Hayek refered very frequently to figures of 19th century as Cobden Bright or Gladstone etc….

      In a recent mail, i was exposing the paramount importance of the “spectre” or “the mirage” as a persistance of an ideology where the historical context is changing : this reminds us the famous sentence of Marx about the “spectre of communism”.

      Neoliberalism must be defined as the “resurrection ” of liberalism (as an ideology) in a new historical context : the resurrection of liberalism as a spectre.

      This new historical context retroactively change the history of liberal tradition: the main objective of the history of ideas written by Hayek is to “normalize ” adam smith as the foundator of the political economy in order to define economic theory as the ideology wich legimitate the ruling class of bourgeoisie.

      This normalization of Smith aims to separate elements of Smith’s theory wich were influencing Marx.

      This is why Hayek maked an appraisal of Carl Menger wich related the question of institution (or the ruling class ) and the theoretical science as the ideology.

      The neoliberal narrative is the beginning of Hayek’s epistemological investigation where the question of knowledge (ideology and utopia) is associated to institution (the ruling class).

      This is the very meaning of Hayek’s “economics and knowledge” where economic theory (objective knowledge) is the ideology legitimating the ruling class (bourgeoisie, oligarchy).

      Hayek’s neoliberal capitalism is the “resurrection” of 19th capitalism.

      Thank you so much.

      Djefaflia Nadir.
      Université Paul Cezanne.
      Aix en Provence.

  3. And where is debt in this theory. Robert Lucas argues that it does not matter. If you look at KPIF the deviation from 2% is not big. The private debt expansion has been rapid. So one can argue that considering debt expansion the interest rate has been too low as debt should increase in relation to productivity otherwise there will be debt problems ahead. If debt increases too quickly there is a trap which causes very big problems as we now can see in many OECD-countries.

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