Friday, 18 September 2015

Extraordinary ignorance

We got a remarkable insight recently into something very odd indeed in New Zealand, and it came from a rather unlikely source, the latest Brookings Papers on Economic Activity conference.

One of the papers presented was 'Inflation targeting does not anchor inflation expectations: Evidence from firms in New Zealand', a paper with four co-authors, one being AUT's Saten Kumar. You can read the abstract and media release, or the whole paper: even if you don't often read more academic papers, this one's worth it. It's pretty easy to follow - indeed, the authors have a rather non-academic flair for making their points crisply and colourfully.

The main focus of the paper is whether inflation expectations are 'anchored': roughly, do people clearly believe that inflation will stay reliably low? They look at five possible ways of assessing it: for example, do expectations vary very widely across the population rather than most people being in the same sort of place? Do expectations jump all over the place from one time period to the next? And so on.

On all five criteria, they find that the business managers they polled did not have settled inflationary expectations. As the abstract puts it
Managers of these firms display little anchoring of inflation expectations, despite twenty-five years of inflation targeting by the Reserve Bank of New Zealand, a fact which we document along a number of dimensions. Managers are unaware of the identities of central bankers as well as central banks’ objectives, and are generally poorly informed about recent inflation dynamics. Their forecasts of future inflation reflect high levels of uncertainty and are extremely dispersed as well as volatile at both short and long-run horizons. Similar results can be found in the U.S. using currently available surveys.
This leads into all sorts of serious cogitation about the efficacy of monetary policy, the need for central banks to communicate better, and how people form their inflation expectations, and if you're a monetary policy tragic you'll love it.

But it also says something pretty damning about the level of ignorance among New Zealand's business community. I'll pass quickly over the facts that only 31% of managers could identify the main objective of the Reserve Bank, and that only 30% could name its governor (even when, in both cases, they were given prompt sheets of the possible answers), and concentrate on this one. Here's a table (clipped from table 7 of the paper) of responses to the question, what inflation rate do you think the RBNZ is trying to achieve? Column 1 shows the possible answers, column 2 shows the percentage of managers who opted for each possible answer, and column 3 shows what they thought actual inflation would be over the following year.

As the authors summarised it, "Of the respondents, only 12% correctly responded 2%, although an additional 25% said either 1% or 3%, the bottom and top of the target range of the RBNZ. But 15% said the RBNZ’s target inflation rate was 5%, 36% said the target was more than 5%, with 5% of respondents saying that the RBNZ’s target inflation rate was 10% or more". Just over half (50.9%) thought that inflation was going to be at least 5%. It turned out to be 0.8% (year to December '14).

Now, I know that there will be a lot of managers doing a perfectly acceptable job of getting the widgets made and out the door, with or without knowing what the rate of inflation is or exactly what the Reserve Bank is trying to do. I'd suggest, particularly if they come anywhere near the strategic planning end of the business, that they're nowhere near as effective as they might be, but there's surely a valid role for heads down, bums up, and get the salads packed and despatched.

And I know that those of us who are into macroeconomics can sometimes forget that others aren't as familiar with the jargon and the details, and that you can actually have a life without delving into the national accounts or the CPI. People get caught up in their own preoccupations, but we don't all need to know the niceties of the LBW rule.

And I know that other countries can be just as bad: the paper documents a similar pattern in the US, though that's little comfort. Not many of us would like to be found on a par with what's happening in twilight Trump-or-Cruz America.

Apologetics apart, though, let's face it: this is a staggering level of ignorance. It makes you ask, among many other things, what on earth the secondary schools can have been teaching in their economics classes over the last twenty years. It leaves you thinking that one of the reasons for our well-documented issues with productivity might well be ill-equipped management. And it makes you wonder about the level of understanding voters have brought into the polling booths: as I've written before, every general election has brought proposals for changing our monetary policy regime, ranging from the potentially promising to total nonsense. How likely is it we'll get a good outcome when people have only the foggiest idea of the current arrangements?

A statistical addendum The first, and often the only, rule when you find extraordinary data like these, is that the data are wrong. They've been mismeasured, someone didn't clean the test tubes, there's an error in the spreadsheet. And I can't quite shake the doubt in this case that there might be a self-selection bias in the survey the researchers carried out. When they first sent the questionnaires out, they got a 20% response - a pretty good outcome. But what if the more clued-in managers opened the envelope and said, "Jeez, I've done enough of these, I'll pass", and the less clued-in ones said, "Wow, no-one's asked for my opinion before"? And if that happened, the potential self-selection bias probably became more acute as an issue in later waves of the survey, since the researchers only went back to people who responded to the first wave. There's a risk that the surveys could have progressively zeroed in on the most clueless. Whether it happened, or what difference it might have made, I can't tell, and it might be completely off the mark, so I'll take the data at face value. Overseas evidence of the same ignorance is rather suggestive that this paper is broadly right anyway.


  1. Why would one care about aggregate inflation? What is more important to firms is the PPI. The authors show (in NBER WP #21092) that firms are perfect in estimating their product inflation.

  2. Thanks for the comment and the reference, which I've downloaded. It's a very interesting paper.
    First of all I agree that you'd imagine firms would have greater incentive and greater opportunity to monitor PPIs, and as you say they do a far better job of tracking PPIs than the CPI, and their average PPI estimate is indeed the same as the actual, so 'perfect' in that sense, yes, though there is still quite a wide distribution of estimates around the (correct) mean. Also firms say (as Appendix 6 shows) that they think there is little or no link between changes in their unit costs and the aggregate inflation rate.
    But you'd still think that, while lower in the pecking order of importance than PPIs, that CPIs would still matter to some degree. If a supplier pulls out the rate card and says, I'm raising my prices to you by 5%, wouldn't firms be interested in knowing whether that is reasonable or unreasonable? If the union comes and says, we're after a 5% wage increase? And how do firms judge what the real interest rate is?
    I see that the paper does say (p30) that "Many firms view inflation as unimportant to their business decisions and choose not to track its recent values", which is in line with your comment, but it also says (p21) that "firms’ responses to these questions [what would you do if inflation turns out higher than you thought] suggest that their inflation expectations do have a direct impact on their economic decisions". It may be modest or second order, but you'd expect something.
    All that said, this paper too is full of interesting stuff. The overall 'rational inattention' premise looks well backed, and I was struck by the differences between industries, and how firms reacted in particular to bad news about the economy.
    I've only read it once, and reasonably quickly, so I may come back to it again either here in the comments or in the blog. Thanks for pointing to it.

  3. The results are almost literally unbelievable. I cannot see how anybody with a responsibility for setting wages or prices or writing contracts could possibly really believe that the RBNZ was targeting some number above 5%. I suspect there's a divergence between the crap people will say in surveys and how they actually behave. Surely, whatever their beliefs on survey-day about inflation, they peek at the numbers before writing the contracts.