The Unexpected Implications of Expectations

As Market Monetarists, we always stress that expectations matter. But how can we test this hypothesis? One way we do this is to use financial evidence such as TIPS spreads to show how changes in monetary policy expectations directly affect market conditions. Evan Soltas recently tried to use a different method: surveys. He put together a series of graphs documenting changes in forecaster expectations around the time of the financial crisis, and claims that the graphs suggest that a "sudden collapse of short-to-medium expectations...could be more important than current-quarter NGDP."

But I disagree with Evan on how we should interpret such results. I took a look at the Survey of Professional forecaster data and restrict my analysis to the Great Moderation period since 1990. I also focus in on the 1 year forward NGDP forecast, as the 1 quarter forecasts give qualitatively similar results.

Like Evan, I too observe that current nominal GDP expectations are related to real variables, such as unemployment. However, the overall relationship is quite weak. NGDP expectations can only explain about 5% of the variation in unemployment. Moreover, the slope estimate is likely to be biased downwards as autocorrelation means the true slope is even closer to zero.

However, even if the correlation were stronger, it still would not say anything about the causal effect of future expectations on current conditions. Any observed correlation could simply be rational expectations at work, with causation running from unemployment to NGDP. Because unemployment is high now, it would be rational to assume that future nominal GDP will be slightly lower. Even if the Fed were more powerful, there would still be some imperfection in the implementation of monetary policy that would cause expectations to shift downwards.

To control for this, we need to look not at the change in expectations, but rather changes in surprises. A big theme in nominal GDP disucssions is that nominal prices are sticky. Therefore, when NGDP falls below trend, because past nominal contracts were set under the expectation of the higher trend, markets fail to clear and we have a fall in real growth. Therefore, if this transmission channel were true, when NGDP falls below what was expected, we should expect to see a significant impact on unemployment.

In other words, we should consider whether actual nominal GDP hit forecasts or if it fell short. This way we can construct an error index that measures to what extent forecasters over or underestimated. Positive numbers denote when actual nominal GDP outperformed the forecast, and thus the dramatic fall into negative territory during the financial crisis reflects the unexpected nature of the nominal GDP shock.

While it certainly did fall during the financial crisis, if you use ordinary least squares regression on this index against variables of interest, such as unemployment, you will not find any kind of systematic correlation. However, if you consider only the extreme cases in which the forecast undershot reality by more than 4%, then you do get a significant negative correlation:

Perhaps this evidence suggests that expectations have a nonlinear impact on unemployment, but at that point we are drawing epicycles that the regression evidence does not warrant.

Does this all mean that expectations are useless? On the contrary. When investigating these expectation surveys, I did manage to uncover the following chart comparing forecasts and actual nominal GDP growth. I lagged the actual NGDP by 1 year, so it is easier to compare how the forecast compares with actual growth.

What we can see is that the forecasters, while not perfect, still do a rather good job of identifying times of distress. Given that forecasts do carry information, then this opens up a role for policy to lean against the wind. The Fed, instead of waiting for all the data to come in, could use a joint forecast-contemporary data criterion. If the forecasters are projecting slow future growth, then the Fed could announce that it is aware of a potential problem and prepare the necessary policy machinery, conventional or otherwise, to combat that threat.

Expectations matter, but we need to be clear on why. While they may have a direct impact on growth, expectations also serve as a crucial lens into the future and can carry information content for policy makers. Armed with such tools, monetary policy can turn towards the future, lean against the wind, and in doing so remedy demand shocks before they start to hurt. 

Forward Looking Markets in Japan

Even though Shinzo Abe has not yet cemented in a new era of Japanese monetary policy, markets have already been preparing for such an event. The market response is a good illustration of how markets act in a forward looking manner.

First, we need to identify when the international community started to focus in on Shinzo Abe. For this, we can look at Google's international search intensities:

From here, we can identify the time around December 15th to be the starting point. Now let's take a look at how markets have responded since then.

First, the exchange rate. Easier monetary policy raises aggregate demand, accelerating NGDP growth and depreciates the currency. Even though the statutory monetary policy framework hasn't changed, the yen has already lost around 7% of its value relative to the dollar since December 14th:



Exhibit 2, the Stock Market. In the same time period, the Nikkei 225 index has risen over 9%. To give this some perspective, almost one-third of the gains over the course of the past year have been the result of the past month of advances.



These statistics are quite striking when you think about the policy controversy surrounding Japan's "lost decade" and the hundreds of trillions of yen that went into public works programs.

Also, these statistics are quite interesting for the "long and variable leads" perspective on monetary policy. Historically, the money supply has not had a large effect on real variables such as GDP. In fact, if you really dug into the 5 year rolling correlations, you would find that, most of the time, quarterly money supply growth actually had a negative correlation with quarterly real GDP growth in that period.



Yet just in the past month, a few "open mouth operations" have seemed to dramatically change market perceptions of monetary policy. This suggests that the mechanical money printing is quite powerless without effective expectations management. As such, there should be significant gains to Shinzo Abe's drive to change the Japanese monetary regime.

On a separate non-economic, purely speculatory note, I'm not sure how the nationalism issues brought up by Noah Smith would interact with this drive to make monetary policy more inflationary. On one hand, if monetary policy is seen as a driver to achieve national ambitions, then the nationalist drive may reinforce the increase in aggregate demand. That would be good. But the worrisome possibility, which worries me more than the possibility that Shinzo Abe will give up on monetary policy, would be that the monetary policy stimulus will be too effective and further stoke nationalist ambitions. The last thing we need is some stupid quibble over the Diaoyu islands that leads to a face-losing and economy destroying outcome for everybody.

Update 1/19/13:

Scott Sumner emails me with the following comment:

"Abe actually started pushing for a 2% inflation target during the campaign, in mid-November. The day of his first speech is the exact the the huge stock rally began, and the exact day the yen began falling sharply. I did a post that day, or perhaps the next. 

http://www.themoneyillusion.com/?p=17736 

It's hard to disentangle money printing and expectations. Think of the following thought experiment: The central bank doubles the money supply and is expected to cut it in half 3 days later. Everyone agrees that there is little effect on markets or AD. So in some sense we are always implicitly making assumptions about monetary policy. On the other hand, I can easily envision where big changes in the money supply also contain information about future expected monetary policy, even if not made explicit. So I can envision QE "working" at least to some extent, even w/o an explicit promise regarding future policy."

Looking back at the data, I should have been more careful with the timing issue. Although the November 15th spike looks minimal, it is only because the December spike was much larger. Focusing in on that one month of the Google data yields the following graph:




On the relationship between money printing and expectations management, I agree with Scott that money "printing" policies, such as QE, can have significant effects even without explicit open mouth operations. The Fed doesn't need to announce a NGDP target for those policies to have effect. But the point with Japan is that effective communications policy can enhance monetary policy. Given that money supply expansion hasn't been sufficient in the past, perhaps a more powerful target will do the trick.

Very Quick Thoughts on (Chinese) Healthcare

The problems consumers face in the Chinese health care system may suggest that the information asymmetries and uncertainties in the provision of health care are much more difficult that we think.

In China, a significant issue that I hear complaints about is that there never is enough capacity. Hospitals are crowded, and it's hard to get adequate care. Instead, doctors spend minimal time with the patient, medicate them to the maximal extent, and then send the patient on his way.

Even when you do get medicines, there's no guarantee that they are the best value for the patient. Many Chinese doctors get commission from companies based on the prescriptions they push forward to their patients, and are thus incentivized to recommend the more expensive imported medicines.

Why does this persist? I suspect it is a combination of both government failure and market failures.

Let us start with the market failures. First, it seems clear that the market is not competitive. Otherwise, perhaps more hospitals could be built to help mitigate the overcapacity. But the most obvious solution -- encouraging more entry by lowering regulatory barriers -- may not be the most effective. In such a world, there would be two tiers of health care, the first being the traditional system that we have now, the second being the new deregulated system.

In the second system, I fear that it may become dominated with fraudulent medicines and unscrupulous doctors. In China, it's already a common frustration that goods that you buy never seem to be real, and whenever there is a profit opportunity, fake goods appear. At best, this wastes money. At worst, this wastes lives. As a result, I have a hard time imagining that deregulation would go off without a hitch.

I also doubt word of mouth would do much to solve these information problems in the second tier. It's hard to tell the differences between charlatans, and as such it would be much easier for consumers (who are predominantly old) to group the entire second tier collectively as ineffective. The difficulty consumers face in evaluating the quality of care also makes it harder for the market to converge on a fraud-free equilibrium. Moreover, if consumers need relatively limited amounts of healthcare, then it's hard for them to learn from experience.

As such, while deregulating the provision of health care in this way could improve health care by giving much more choice to consumers, it does not seem sufficient. The lack of competition seems to be the result of these information asymmetries, and to address the lack of competition you have to first address the problems in getting information.

Yet this story of market failures may instead be a story of government failures. In the case of overmedication, the government does have laws on the book in order to mitigate it. Their solution is to control the prices of individual drugs as well as limit the total monetary value of drugs that a doctor can prescribe in a single visit. However, doctors then respond to this by reducing the length of prescriptions, and then having patients come to the hospital more often. This contributes to the capacity issue because patients are forced to come to the hospital more often.

Also, because prices are controlled, patients have to "walk the back door" (走后门) and pay additional bribes to doctors to get care. This exacerbates the imported drug problem, because if doctors cannot earn as much money through conventional means, it is natural that they find ways to work around the system to make the money.

Price controls are also problematic because they make investing in new medicines very risky. Even if a given company can create a drug, it's always uncertain how the government will regulate it.

Based on these competing narratives, I draw two broad conclusions.

First, crude price regulation is rarely an answer. In such a world, it's too easy for people to work outside the system (in the case of bribes) or for doctors to subtly change their work inside the system (in the case of overmedication). Instead, if regulation is to work, it needs to address reasons, like asymmetric information, why health care provision hasn't been working like in a regular market.

Second, consumer choice is insufficient. As healthcare consumption becomes dominated more and more by the elderly, it strikes me as very odd that the most feeble in society are now tasked with identifying the best form of healthcare in an environment that is growing increasingly complex. There is just too much uncertainty, both ex-ante and ex-post, about the quality of care, for the standard word of mouth and experienced buyer mechanisms to work.