Written by Maren Blanchard
Many of us know at least one person who is chronically late. If you tell them that dinner is at 5:00 PM, you will be waiting for them until at least 5:30. You understand their patterns and how they will behave based on the information you give them. Now, assume that you and your chronically late friend have a very important reservation. If both parties are not on time, you risk having your seats offered to another group. Your reservation is for 7:00 PM. In this situation, assume you are faced with two options: telling your friend the reservation is at 7:00 and risking them being late, or, telling them the reservation is at 6:15 and hoping that they will arrive by the real reservation time. We are often taught that honesty is the best policy, but in this case, what would be the harm in lying? It is not difficult to see how offering false information about the reservation time would benefit both parties: the friend does not have to feel guilty about their tardiness, and you do not have to wait for them and lose your reservation. When we continuously observe patterns of someone else’s behavior based on the information they are given, we have the opportunity to manipulate the information we give them in order to change the results.
A similar mechanism is observed with the Federal Reserve. In setting inflation rates, the Fed seemingly stands to benefit from relaying incorrect information to the general public to influence their behavior. If the central bank of an economy wants to achieve an output above the current economy’s potential, one way to accomplish this is to set a higher inflation rate. Intuitively, we can understand the importance of the Federal Reserve’s statements regarding inflation, as consumer spending will be influenced by their expectations of the future. If consumers believe that inflation will be rising throughout the year, they expect the purchasing power of their dollars to decrease and will have an incentive to consume less and save more. This behavior would allow them to purchase necessary expenses when the relative prices rise. Therefore, if consumers expect a higher level of inflation, they will adjust their spending behaviors, ultimately preventing the desired output above potential from being reached. The Federal Reserve understands how consumer expectations will influence the market and how accurate expectations will prevent the attainment of a higher output. However, the Federal Reserve also knows that it has the power to influence expectations. If the Fed were to imply that they are fighting inflation and expect a level of inflation that is far lower than what they truly expect, then consumers would likely believe and act upon expectations of the lower inflation rate. This means that they would not adjust their behaviors in a way that would counteract the Federal Reserve, and the Federal Reserve’s goal of a higher output could be reached.
The situation in which it is optimal to promise one policy but act on another can be referred to as dynamic inconsistency (Zamulin, 2023). In the example of a tardy friend, the promised policy may be leaving at X time, but acting on the policy of leaving at time Y. For the Federal Reserve, the promised policy may be setting an inflation rate of 1% and acting on the policy of setting a 5% inflation rate. In each scenario, there is a clear incentive to deceive the other party. If there are benefits to dynamic inconsistencies, then why is it so rare?
Even if this strategy were to prove beneficial, there is an aspect that is important to consider: trust. In situations where two parties will interact repeatedly, it is necessary to consider how the actions taken in one period of time may affect future interactions. Many would likely have a hard time believing information from a source that has previously been inaccurate. Following our reservation analogy, if you tell your friend every time that your plans begin far before they actually will, they will eventually realize that you are giving them the wrong information and will adjust their behavior. Since you often suggest they arrive 45 minutes prior to the actual reservation, they will likely infer that since you relay wrong information, the real reservation time is not the time you tell them, rather 45 minutes thereafter. If they remain chronically late, you will revert to your initial position, and your friend will likely be less trusting towards you. We expect the same thing to occur with the Federal Reserve. If the inflation rates they suggest to the public are continuously unaligned with the actual observed inflation, Americans will lose confidence in the Federal Reserve’s information and will continue to expect high inflation regardless of what the Fed announces.
A lack of trust in the Federal Reserve would pose a great threat, as the Fed’s power to influence the economy could be weakened. Currently, the Federal Reserve holds great influence and power over the choices of American consumers and businesses. Comments made by Federal Reserve Chairman, Jerome Powell, have significant effects on investments, interest rate expectations, and unemployment (Horsely, 2023). If the Fed were to build a reputation of deceiving Americans, the economic effects could be dire. Furthermore, another issue is that the success of a dynamically inconsistent policy is based on a model economy that is operating at potential. As with many examples in economics, real markets are not as simple as models; we cannot be sure that the effects of certain policies will translate from economic models to the real United States economy. With the current state of our economy, many (including Bill Dudley, former president of the Federal Reserve Bank of New York) believe that the Fed should stick to their current target (Sommer, 2023). While economists differ on what the inflation target should be and how quickly the targets should adjust, there is little argument made for adopting a policy of dynamic inconsistency. The trust and credibility of the Federal Reserve helps drive our economy, and if Americans lose that confidence, there will be much more at stake than simply losing a dinner reservation.
References
Horsley, S. (2023, March 7). Federal Reserve chair Jerome Powell warns inflation fight will be
long and bumpy. NPR. Retrieved April 7, 2023, from https://www.npr.org/2023/03/07/1161623217/federal-reserve-jerome-powell-senate-inflation-interest-rates-economy-recession#:~:text=%22Although%20inflation%20has%20been%20moderating,bumpy%2C%22%20Powell%20told%20senators
Sommer, J. (2023, March 24). The Fed has targeted 2% inflation. should it aim higher?
The New York Times. Retrieved April 7, 2023, from https://www.nytimes.com/2023/03/24/business/inflation-federal-reserve-interest-rates.html
Zamulin, O. (2023, March 13). Lecture 9: Monetary Policy [PowerPoint Slides]. University of Michigan Intermediate Macroeconomic Theory Canvas. https://canvas.umich.edu