I used to mock the idea of the “expectations fairies” — at least in the context of neoclassical theory. However, Keynes’ “animal spirits” is back, we are running into a situation that does not have a lot of precedents in the post-World War II era. The brain trust in the White House has done a lot of things, but very few of them so far would have macroeconomic impact (outside of countries where US aid was significant). Instead, the issue is the effect of future actions.
Expectations Fairies Silliness
The silly side of Expectations Fairies came from Dynamic Stochastic General Equilibrium (DSGE) macro models. In those models, prices determine everything, and those prices are determined by “supply and demand” over present and future markets (going out to infinity in benchmark models). The central bank reaction function was a key component of pinning down price expectations, and lo and behold, the models “predicted” that inflation would follow a central bank inflation target.
If the central bank function was a simple rule — like the “Taylor Rule” — you got reasonably plausible model behaviour. (Plausible if you are a neoclassical economist, at any rate.) The problem is that certain zealots (e.g., the Market Monetarists) took these models literally, and they actually argued that the central bank determines the price level each and every day by announcing a price target. As such, by controlling the “expectations fairies,” the central bank could achieve any feasible economic trajectory (e.g., nominal GDP targeting).
The zealots were aided by the economists’ decisions to use “expectations” to describe the market clearing price in forward markets. This sort-of made sense when we use the mathematical term expected price — which is the probability-weighted average price. Fixed income mathematics is built around the concept — forward prices are the expected prices (by definition), and option prices are based on the probability distribution around that expected value. The problem is that human beings like confusing the mathematical expectation with the common English meaning of “expectations” (which I denote as forecasts).
In practice, the ability of central banks to affect forecasts about the economy (but perhaps not fixed income markets, which they can bash around with their balance sheet) was more limited than what neoclassical propaganda suggested. However, “animal spirits” certainly mattered. However, in most cases, “animal spirits” tended to follow developments in the real economy. In the current environment, not that much is happening in the real macro economy, but animal spirits are now moving a lot.
Perhaps Living in an Information Bubble is Dangerous
The latest puke-o-thon in equity markets appears to be related to Trump appearing sanguine regarding near-term recession risks. The White House brain trust had certainly been pushing the “liquidations are good for the economy, actually” for some time now, but now the ageing monarch has finally piped up.
Investors had assumed (and frankly, I am one of them) that stock market weakness would force reversals by Trump. However, it appears that the White House exists solely in an information bubble where feedback of negative events are not allowed to enter. This eliminates “The Trump Put” of his first term, where falling stock markets forced a reversal of ill-advised policies.
I am willing to accept that falling stock markets will finally register on the White House at some point, but it is not clear how much deeper they have to fall in order to trigger any reaction. At the same time, the remaining industrial democracies have little choice but to re-think their contractual links with America, and thus restructuring is the order of the day — even concrete actions triggering the restructuring are so far limited.
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