Estimation of Historical Inflation Expectations

The final version of my paper "Estimation of Historical Inflation Expectations" is now available online in the journal Explorations in Economic History. (Ungated version here.)

Abstract: Expected inflation is a central variable in economic theory. Economic historians have estimated historical inflation expectations for a variety of purposes, including studies of the Fisher effect, the debt deflation hypothesis, central bank credibility, and expectations formation. I survey the statistical, narrative, and market-based approaches that have been used to estimate inflation expectations in historical eras, including the classical gold standard era, the hyperinflations of the 1920s, and the Great Depression, highlighting key methodological considerations and identifying areas that warrant further research. A meta-analysis of inflation expectations at the onset of the Great Depression reveals that the deflation of the early 1930s was mostly unanticipated, supporting the debt deflation hypothesis, and shows how these results are sensitive to estimation methodology.

This paper is part of a new "Surveys and Speculations" feature in Explorations in Economic History. Recent volumes of the journal open with a Surveys and Speculations article, where "The idea is to combine the style of JEL [Journal of Economic Literature] articles with the more speculative ideas that one might put in a book – producing surveys that can help to guide future research. The emphasis can either be on the survey or the speculation part." Other examples include "What we can learn from the early history of sovereign debt" by David Stasavage, "Urbanization without growth in historical perspective" by Remi Jedwab and Dietrich Vollrath, and "Surnames: A new source for the history of social mobility" by Gregory Clark, Neil Cummins, Yu Hao, and Dan Diaz Vidal. The referee and editorial reports were extremely helpful, so I really recommend this if you're looking for an outlet for a JEL-style paper with economic history relevance.

My paper grew out of a chapter in my dissertation. I was interested in inflation expectations in the Great Depression after serving as a discussant for a paper by Andy Jalil and Gisela Rua on "Inflation Expectations and Recovery from the Depression in 1933:Evidence from the Narrative Record." I also remember being struck by  Christina Romer and David Romer's, (2013, p. 68) remark that a whole “cottage industry” of research in the 1990s was devoted to the question of whether the deflation of 1930-32 was anticipated.
I found it interesting to think about why different papers came to different estimates of inflation expectations in the Great Depression by examining the methodological issues around estimating expectations when direct survey or market measures are not available. I later broadened the paper to consider the range of estimates of inflation expectations in the classical gold standard era and the hyperinflations of the 1920s.

A lot of my research focuses on contemporary inflation expectations, mostly using survey-based measures. Some of the issues that arise in characterizing historical expectations are still relevant even when survey or market-based measures of inflation expectations are readily available--issues of noise, heterogeneity, uncertainty, time-varying risk premia, etc. I hope this piece will also be useful to people interested in current inflation expectations in parts of the world where survey data is unreliable or nonexistent, or where markets in inflation-linked assets are underdeveloped.

What I enjoyed most about writing this paper was trying to determine and formalize the assumptions that various authors used to form their estimates, even when these assumptions weren't laid out explicitly. I also enjoyed conducting my first meta-analysis (thanks to the recommendation of the referee and editor.) I found T. D. Stanley's JEL article on meta-analysis to be a useful guide.

Regime Change From Roosevelt to Rousseff

I've written another post for the Berkeley Center for Latin American Studies blog:

President Franklin Delano Roosevelt was elected in October 1932, in the midst of the Great Depression. High unemployment, severely depressed spending, and double-digit deflation plagued the economy. Shortly after his inauguration in March 1933, a dramatic turnaround occurred. Positive inflation was restored, and 1933 to 1937 was the fastest four-year period of output growth in peacetime in United States history. 

How did such a transformation occur? Economists Peter Temin and Barrie Wigmore attribute the recovery to a “regime change.” In the economics literature, regime change refers to the idea that a set of new policies can have major effects by rapidly and sharply changing expectations. A regime change can occur when a policymaker credibly commits to a new set of policies and goals.... 

In short, Roosevelt stated and proved that he was willing to do whatever it would take to end deflation and restore economic growth. As Roosevelt proclaimed on October 22, 1933: “If we cannot do this one way, we will do it another. Do it, we will.” 

Almost all politicians promise change but few manage such drastic transformation. In Brazil’s closely contested presidential election this October, incumbent President Dilma Rousseff won reelection with a three-point margin over centrist candidate Aecio Neves. Rouseff told supporters, “I know that I am being sent back to the presidency to make the big changes that Brazilian society demands. I want to be a much better president than I have been until now.” 

Rousseff’s rhetoric of “big changes” refers in large part to the Brazilian economy, which is plagued with stagnant growth, high inflation, and a strained federal budget. Brazil’s currency, the real, hit a nine-year low following Rousseff’s victory, and the stock market also tumbled. This market tumult reflects investors’ doubts about the Rousseff administration’s intention and ability to enact effective reforms. Investors viewed Neves as the pro-business, anti-interventionist candidate and are unconvinced that Rousseff will act decisively to restore fiscal discipline and rein in inflation. In other words, Rousseff’s talk of change is not fully credible in the way that Roosevelt’s was... 

Though Rousseff is taking some actions to improve business conditions, restore fiscal discipline, and reduce inflation, the problem is that they are being enacted quietly and reluctantly rather than being trumpeted as part of a broader vision of reform. The key to regime change is that the effects of policy changes depend crucially on how the changes are presented and perceived. Economic policies work not only through direct channels but also through signaling and expectations. For example, a small rise in fuel prices and a reduction in state bank subsidized lending may have small direct effects, but if they are viewed as signals that the president is wholeheartedly embracing market-friendly reforms, the effects will be much greater. So far, despite Rousseff’s campaign slogan — “new government, new ideas” — she hasn’t credibly committed to a new regime.

Read the complete article and my pre-election Brazil article at the CLAS blog.

Reading Keynes at the Zero Lower Bound

The Berkeley Economic History Lab working paper series has recently put up a new paper by Richard Sutch, "The Liquidity Trap, the Great Depression, and Unconventional Policy: Reading Keynes at the Zero Lower Bound." From the abstract:

The developed economies of Japan, the United States, and the Eurozone are currently experiencing very low short-term rates, so low that they are considered to be at the “zero lower bound” of possibility. This effectively paralyzes conventional monetary policy. As a consequence, monetary authorities have turned to unconventional and controversial policies such as “Quantitative Easing,” “Maturity Extension,” and “Low for Long Forward Guidance.” John Maynard Keynes in The General Theory offered a rich analysis of the problems that appear at the zero lower bound and advocated the very same unconventional policies that are now being pursued. Keynes’s comments on these issues are rarely mentioned in the current discussions because the subsequent simplifications and the bowdlerization of his model obliterated this detail. It was only later that his characterization of a lower bound to interest rates would be dubbed a “Liquidity Trap.” This essay employs Keynes’s analysis to retell the economic history of the Great Depression in the United States. Keynes’s rationale for unconventional policies and his expectations of their effect remain surprisingly relevant today. I suggest that in both the Depression and the Great Recession the primary impact on interest rates was produced by lowering expectations about the future path of rates rather than by changing the risk premiums that attach to yields of different maturities. The long sustained period when short term rates were at the lower bound convinced investors that rates were likely to remain near zero for several more years. In both cases the treatment proved to be very slow to produce a significant response, requiring a sustained zero-rate policy for four years or longer.

Sutch notes that "the General Theory is a notoriously unreadable book, one that required others to interpret and popularize its message." Since Keynes did not use the phrase "liquidity trap"--it was coined by Dennis Robertson in 1940--interpreting Keynes' policy prescriptions in a liquidity trap is contentious. Sutch reinterprets the theory of the liquidity trap from the General Theory, then examines the impact of Federal Reserve and Treasury policies during the Great Depression in light of his interpretation.

Sutch outlines Keynes' three theoretical reasons why an effective floor to long-term interest rates might be encountered at the depth of a depression:

(1) Since the term structure of interest rates will rise with maturity when short-term rates are low, a point might be reached where continued open-market purchases of shortterm government debt would reduce the short-term rate to zero before producing a sufficient decline in the risk-free long-term rate [Keynes 1936: 201-204 and 233]. 

(2) It is, at least theoretically, possible that the demand for money (called “liquidity preference” by Keynes) could become “virtually absolute” at a sufficiently low longterm interest rate and, if so, then increases in the money supply would be absorbed completely by hoarding [Keynes 1936: 172 and 207-208]. 

(3) The default premiums included as a portion of the interest charged on business loans and on the return to corporate securities could become so great that it would prove impossible to bring down the long-term rate of interest relevant for business decisions even though the risk-free long-term rate was being reduced by monetary policy [Keynes 1936: 144-145].

The first two reasons, Sutch notes, are often conflated  because of a tendency in the post-Keynesian literature to drop short-term assets from the model. The third reason, called "lender's risk," is typically neglected in textbooks and empirical studies.

In Keynes' view, the Great Depression was triggered by a collapse in investment in 1929, prior to the Wall Street crash in the fall, as “experience was beginning to show that borrowers could not really hope to earn on new investment the rates which they had been paying” and “even if some new investment could earn these high rates, in the course of time all the best propositions had got taken up, and the cream was off the business.” Keynes maintained that a reduction in the long-term borrowing rate, to low levels would be required to stimulate investment after the collapse of the demand curve for investment. He suggested that the long-term borrowing rate has three components: (1) the pure expectations component, (2) the risk premium, and (3) the default premium.

Sutch goes on to interpret the zero lower bound episodes of 1932, April 1934-December 1936 and April 1938-December 1939 according to Keynes' theory. He concludes that the primary impact of unconventional monetary policy on interest rates was through lowering expectations about the future path of rates rather than by changing the risk premiums on yields of different maturities---but this impact was very slow. Sutch also concludes that a similar interpretation of recent unconventional monetary policy is appropriate. He notes four main similarities between the Great Depression and the Great Recession:

...the collapse of demand for new fixed investment, the role of the zero lower bound in hampering conventional monetary policy, the multi-year period of near-zero short term rates, and the protracted period of subnormal prosperity during the respective recoveries. A major difference between then and now is that in the current situation the monetary authorities are actively pursuing large-scale purchases of long-term government securities and mortgage-backed assets. This is the primary monetary policy that Keynes advocated for a depressed economy at the zero lower bound. This policy was not attempted during the Great Depression and it is unclear whether the backdoor QE engineered by the Treasury was an adequate substitute. 

While the current monetary activism is to be welcomed, Quantitative Easing then and now appears to be slow acting. In both regimes recovery came only after multiple painful years during which uncertainly damped optimism. Improvement came only after multiple years during which many lives were seriously marred by unemployment and many businesses experienced or were threatened with bankruptcy...Keynes opened his series of Chicago lectures in 1931 expressing the fear that, just possibly, "… when this crisis is looked back upon by the economic historian of the future it will be seen to mark one of the major turning-points. For it is a possibility that the duration of the slump may be much more prolonged than most people are expecting and that much will be changed, both in our ideas and in our methods, before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semislump, or at least subnormal prosperity which may be expected to succeed the acute phase." [Keynes 1931: 344]

If you are interested in reading narrative evidence from Keynes' writing, the entire working paper is worth your time.