Category: rational expectations

Expectations and Anticipations

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June 16, 2024

This week’s letter continues my study of expectations, focusing on the political aspect. While some economists have treated expectation and anticipation as synonyms (the Stockholm school, for one), I want to distinguish between the two. Expectation is planning for or projecting into the future from an observation point in the present. Anticipation is visionary, an imaginative leap into the future in which some event or state has already happened. Anticipation is intuitive; expectation is calculating.

Anticipation invokes our identity and biases as well as our imagination. Political campaigns often target our sense of anticipation with negative advertising that impugns the candidate, then implies that a vote for such a character is an association with that candidate. Imagine how bad things would be if such a person were elected. Do we really want to be associated with someone like that? At a 2008 Presidential debate between Republican candidate John McCain and Democratic candidate Barack Obama, McCain defended Obama’s character against the innuendo spread by right wing TV and talk radio personalities. Much as we deplore negative political advertising, it is effective.

In the game of chess, each player strategizes to take the other’s king. Getting to the other side of the board first does not win the game. One achieves victory by the opponent’s loss. Elections like those in the U.S. are similar to baseball or football. Preventing the opposing team from scoring will not win the game. The victorious team must also make a score. The winner must get more points than the loser, a typical characteristic of a race, which is why our type of elections are called first past the post voting. What makes an election different than a 100-yard dash are the battle tactics employed to weaken an opponent’s efforts to score votes. Successful campaigns strive to get there first while persuading voters to vote NO on their opponent. Campaigns target two separate processes we use to make choices.

One axiom of rational choice theory in economics is a completeness of preferences – that people are able to weigh the costs and benefits of two options and choose the option that maximizes their self interest. We choose an option that provides what we think will give us the most utility. Yes, we make mistakes, but the errors are random. Behavioral economists have challenged the assumption that our choices are rational, pointing out biases that introduce systemic, not random, error in our choices. Losses have a greater impact on our senses than equal gains. Options may be too complex to evaluate fully before making a choice, so we rely on instinct.

 In Chapter 8 of his book, Optimally Irrational, Lionel Page (2023) discusses the debate and presents several examples that test the axiom. Given two grocery lists, could you pick the best option? Consider there might be twenty or more items on the list and a grocery store carries thousands of items. How could any person decide the best option? This past week, after checking out my groceries, I picked up what I thought was the receipt that had fallen out of my pocket. With a glance, I knew it was not mine because there were a few items on the list that I would never buy. I realized then that I could choose between two random grocery lists in less than a minute. I would scan the list for things that I definitely did not like or want. The list that had the fewest of those would be my choice.

When we do have difficulty making choices, it is because we are trying to choose the best, not the worst, option. Page cited (p. 101) an episode of the Big Bang Theory where Sheldon had difficulty choosing between two computer game consoles. He had approached the problem in a very analytical manner typical of Sheldon and was unable to choose. The shortcut, or heuristic, of decision-making that we use in our daily lives is not finding the best, but establishing the worst of two options. We know our dislikes more than our likes because our dislikes amplify the cost of our decisions, helping us choose the cheaper option with less deliberation. Secondly, identifying the worst alternative makes it more probable that we can live with our decision.

A successful political campaign structures its rhetoric to take advantage of this shortcut in decision making. Just before the 1980 election, candidate Ronald Reagan posed a question to President Carter at an October debate: Are you better off than you were four years ago? Despite the word “better” in the question, this was an “identify and reject the worst” choice using both rational expectations and more imaginative anticipations. On the one hand were the empirical realities of high inflation and unemployment, and the energy shortages that voters had experienced during Carter’s term. Voters could form expectations based on that data. Reagan’s term as Governor of California during the 1960s gave voters some basis to form a rational expectation of a Reagan term. However, much was left to voters’ imaginations to construct a post-hoc, or after the fact vision of a Reagan term. This was the anticipation instinct at work. The question helped turn a  close race into a landslide victory for Reagan.

Some voters may not have a clearly defined worst or judge two candidates to be equally worse. Each may have one or two repulsive personal characteristics, political alliances or policy stances. To appeal to those voters, a political campaign offers hope that their candidate will maximize a voter’s income, personal freedom, autonomy or other circumstance like the health of the community a voter lives in. The negative approach targets the cost calculation that voters make. The positive approach appeals to the benefit calculation, but the negative approach is the more powerful. The disadvantage of the negative approach is that it can persuade voters to abstain from voting. In a national campaign for President, a voter’s abstention is neutral, but a lack of turnout can be a decisive factor in local races where a small number of voters can be the tipping point of a political victory.

I hope I have made a clear distinction between expectations and anticipations. When a person stands in the present and plans ahead for some state or event, she is expecting. When a person stands in an imagined future and looks back at an event, she is anticipating. I will take a closer look at the unintentional political alliances between voters as a result of the symbiosis between expectations and anticipations.

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Photo by Ahmed Almakhzanji on Unsplash

Keywords: campaign, election, choice, anticipation, expectation

Page, L. (2023). Optimally irrational: The good reasons we behave the way we do. Cambridge University Press.

Invisible Expectations

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June 2, 2024

by Stephen Stofka

This week’s letter continues a topic from last week, our expectations of inflation. The high inflation of the 1970s prompted a lot of debate on this topic, and I will try to cover a portion of those ideas. Hypotheses regarding the formation of expectations influence monetary policy and the manner in which the Fed raises interest rates. Different policy approaches reach across the country into the pocketbooks of many Americans. They can mean the loss of many jobs or few jobs, or the viability of buying a home.

The University of Michigan conducts a monthly survey of consumer sentiment in a rotating sample among 500 participants. Respondents are asked to estimate the rate of inflation for the next twelve months (see here, p. 5). Inflation is a rise in the average price of all goods but in casual conversation, we often use the term loosely to refer to a rise in prices of the goods and services that have the most impact on our lives. Each of our estimates are biased but an average of many estimates should approximate a comprehensive survey of the prices of many goods. This BBC five-minute video explains this phenomenon known as The Wisdom of the Crowd when many people try to estimate the number of jelly beans in a mason jar.

The blue line in the graph below is the headline CPI that tracks a basket of goods and excludes expenses like the employer portion of health care insurance. The Fed pays more attention to the PCEPI, the green line in the graph below. That methodology is based on actual expenditures in various sectors of the economy, including employer paid health insurance. Notice how closely the average estimates of inflation approximate this broad measure of price movement. In the April 2024 survey, expectations averaged 3.2%, a big decrease from over 5% in 2022 but a slight rise from 2.9% in March.

How do we form inflation expectations? There are two hypotheses, and they are distinguished by how errors occur in our expectations. Adaptive expectations was a predominant hypothesis until the 1970s. It holds that we revise our forecasts up when actual inflation is higher than we expected, and down when inflation data indicates that our forecast was too high (Blanchard, 2017). Imagine that we are offered a discount at the doctor’s office if we guess our weight within three pounds. We base our guess on a previous weight reading. If it is too low, we lose our discount so the next time we revise our guess higher. Under this hypothesis, our expectations are very much guided by past experience and our forecast errors are systemic. To tame high inflation, monetary policy must act like a shock that induces a recession and alters the expectations of investors and consumers.

In August 1979, during the Carter administration, Paul Volker assumed the position of Fed chair. In October, the Fed raised interest rates 1.5%, then lowered by a half-percent in November, then raised them again by a half-percent in December. In those three months, sales of new one-family homes (HSN1F) dropped 25%. A few months later, in the spring of 1980, came another interest rate shock of a 3.5% increase over two months and new one-family homes sank by 38%. They did not begin to recover until the spring of 1982. This cattle prod approach to taming expectations was influenced by the adaptive expectations hypothesis.

Statistical tests done in the early to mid-1970s showed that we paid much more attention to ongoing conditions than previously thought. This contradicted the notion that our expectations relied mostly on past experience. Two economists, Robert Lucas and Thomas Sargent presented a rational expectations hypothesis claiming that we form the best inflation forecast we can with the information available to us. Rational does not mean perfect. Errors in our forecasts are random and arise from unseen shocks (Humphrey, 1985). The critique against this hypothesis was that people were too naïve or uninformed to form rational expectations. Information frictions blurred the distinction between rational and non-rational (Angeletos et al, 2021).

 Over the past several decades, the rational expectations hypothesis has guided policymaking at the Fed. If the Fed presents a convincing policy commitment to steer inflation toward a particular target, investors will change their behavior in accordance with their belief in the Fed’s commitment. Economist Roger Farmer (2010) has called them self-fulfilling beliefs and devotes a section of his book to rational expectations. Under this regime, the Fed uses steady, incremental rate increases and consistent policy statements to “corral” expectations like a trained sheepdog persistently badgering a flock of sheep to guide them into a holding area. By guiding expectations, monetary policy can tame high inflation without necessarily producing a recession. This has been dubbed a soft landing.

In the spring of 2022, the Fed under Chairman Jerome Powell raised rates a half percent a month, a steady rate to let everyone know that the Fed was serious. From the spring of 2022, the number of new one-family homes did not fall. That was the rational expectations hypothesis at work. The Federal Reserve as sheepdog. As with any comparison, there are a number of other factors. My point here is that ideas about people’s motivations and behavior make a concrete difference in the lives of ordinary people.

We respond to high inflation with behavior that can exacerbate inflation. Next week I will look at several scenarios that illustrate why the Fed is concerned about managing consumer and investor expectations.

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Photo by Hassaan Here on Unsplash

Keywords: housing, interest rates, monetary policy, adaptive expectations, rational expectations, inflation

Angeletos, G.-M., Huo, Z., & Sastry, K. A. (2021). Imperfect macroeconomic expectations: Evidence and theory. NBER Macroeconomics Annual, 35, 1–86. https://doi.org/10.1086/712313

Blanchard, O. (2017). Macroeconomics (Seventh ed.). Boston, MA: Pearson Education. p. 337. This is an intermediate economics textbook.

Farmer, R. E. A. (2010). How the economy works: Confidence, crashes and self-fulfilling prophecies. Oxford University Press. This book contains succinct descriptions of various economic theories that have influenced policy and is aimed toward the general reader.

Humphrey, Thomas M., The Early History of the Phillips Curve (1985). Economic Review, vol. 71, no. 5, September/October 1985, pp. 17-24, Available at SSRN: https://ssrn.com/abstract=2118883