Federal Reserve research paper kills another core New Keynesian idea about inflation expectations

The New York Times article (October 1, 2021, updated October 15, 2021) – Nobody Really Knows How the Economy Works. A Fed Paper Is the Latest Sign – reported on a paper by one Jeremy B. Rudd, who is a senior advisor in the Research and Statistics division at the Federal Reserve Bank in the US. The paper – Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?) – published as Finance and Economics Discussion Series 2021-062, by the Board of Governors of the Federal Reserve System, argues that a core aspect of New Keynesian macroeconomic orthodoxy “rests on extremely shaky foundations … and adhering to it uncritically could easily lead to serious policy errors.” The paper rejects the central notion in mainstream macro that the trajectory of inflation is driven by expectations. The idea that expectations are the key force has led central banks deliberately using the unemployed to fight an (imaginary) inflation threat. It has led fiscal authorities to pursue contractionary policies that have forced millions into unemployment. The Rudd paper is important because it shows the mainstream edifice is collapsing – it jettisons an other core concept. There is not much left in mainstream economics that hasn’t been rejected by evidence or exposed as being theoretically inconsistent.

The New York Times article thinks this is part of a process that is “rethinking longstanding core ideas”.

My view is that the array of dissonant evidence is finally catching up with a profession that has been lazing in its smugness for too long.

As background reading, these blog posts are relevant:

1. The myth of rational expectations (July 21, 2010).

2. The Great Moderation myth (January 24, 2010).

Mainstream macroeconomics tried to convince everyone in the 1990s that their framework had evolved to the point that the interesting questions had been solved.

We were told that mainstream economists had “won” the debate and those stupid keynesians would never see the light of day again.

The arrogance reached previously unknown heights when Robert E. Lucas, Jnr of the University of Chicago stood up to deliver his 2003 – Presidential Address to the American Economic Association and said:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.

In other words the ‘economic cycle is dead’.

Soon after (February 20, 2004), the then US Federal Reserve Board Governor, Ben S. Bernanke made one of the worst speeches by an official of a major policy institution in history when he declared the macroeconomists profession had achieved – The Great Moderation.

The thesis ran that this coincidence of low inflation and continuous economic growth was because free market economists had triumphed over the interventionists who had over-regulated the economy, sucked the enterprise out of private enterprise, allowed trade unions to become too powerful, and bred generations of indolent and unmotivated individuals who only aspired to live on the dole.

Effectively, these economists claimed they had eliminated macroeconomic volatility because they understood the way human behaviour incorporated rational expectations, which posited that they effectively ‘knew’ the future (with a mean error of zero), and would use those expectations to drive economic outcomes that would evade any policy initiatives designed to reduce unemployment and poverty.

The Great Moderation was a celebration of the world of ‘natural’ aggregates (‘Natural Rate of Unemployment’, later called the NAIRU), which were driven by the ‘market expectations’ and would thwart policy attempts to foce a deviation from these market determined outcomes.

The market, the market, the market – go back to the 1980s and 1990s – and that is what the economists were all talking about.

In my graduate studies, the role of expectations was central to the maintaining the ideological case against government intervention.

A major organising framework was the Phillips curve, which graped the unemployment rate on the horizontal axis and the inflation rate on the vertical axis.

You can read some draft notes for our Macroeconomics textbook in the series that you will find linked to in this blog post – Unemployment and inflation – Part 14 (April 19, 2013).

In these blog posts (as part of that series), I explicitly discuss the way expectations came to be dominant in the mainstream story of inflation.

1. Unemployment and inflation – Part 9 (March 15, 2013).

2. Unemployment and inflation – Part 8 (March 13, 2013).

I won’t repeat that analysis which presents the argument in graphical form as used in the mainstream teaching texts and articles on the subject.

In words, during the Keynesian period of policy domination (1960s), it was believed that there was some sort of trade-off between the ‘twin evils’ of inflation and unemployment.

So governments could choose to have lower unemployment (up to some irreducible frictional minimum) if they were willing to tolerate higher inflation.

If they wanted lower inflation, then the cost would be higher unemployment.

The link between the two was largely determined by market pressures – at low unemployment, wages pressure rises and firms pass on the escalating unit costs.

Higher unemployment reduces wage demands and so achieves lower inflation.

This was the way the Phillips curve argument was initially presented after the 1958 publication of A.W. Phillips.

In 1968, Milton Friedman asserted this was all wrong – that in fact, there was no systematic trade-off between inflation and unemployment.

He argued that there was only one sustainable unemployment rate – the natural rate of unemployment, which is determined by the underlying structure of the labour market and the rate of capital formation and productivity growth.

He believed that the economy always tends back to that level of unemployment even if the government attempts to use fiscal and monetary policy expansion to reduce unemployment.

The only long-term outcome of governments trying to ‘beat the market’ (gain lower unemployment) would be accelerating inflation.


Because if governments pushed the unemployment rate down via expansionary fiscal policy – moving the economy along a Phillips curve – the inflation rate would begin to rise.

Initially, workers would not perceive the cuts to their real wages arising from the higher inflation.

Friedman and others argued that eventually workers would realise that their real wage was being eroded in price inflation outstripped money wages growth.

In doing so, they would start to form expectations of continuing inflation.

As a consequence, workers would build these inflationary expectations into their future outlook and pursue real wage increases, which reflected not only the state of the labour market (relative strength of demand and supply) but also how much they expected prices to rise in the period governed by the wage bargain.

The Monetarists argued that if the government attempted to reduce unemployment below the natural rate, then as the inflation rate rose, workers would demand even higher money wages growth to achieve their desired real wage levels.

Ultimately, all that would result was an accelerating price level.

Initially, the trade-off occurs in the short-run because firms exploit the lower real wages and increase employment (this is the old Classical labour market story that Keynes crushed).

Workers supply more labour (hence unemployment falls) because they think their money wages rises are real wage rises. They are fooled by lack of information.

Eventually, workers find out they have been tricked by the price signals and increase their inflationary expectations to accord with the actual inflation rate and at that point some withdraw their labour again (because they prefer leisure to work at the lower real wage) and the economy returns to the ‘natural rate of unemployment’ albeit at a higher inflation rate.

So the introduction of expectations were central to the Monetarist attack on Keynesian fiscal policy activism.

By the mid-1970s, a further development – rational expectations – made the case more forcefully.

Friedman’s initial story assumed their was a period of trade-off, while workers expectations adjusted with some time lag.

The Rational Expectations (RATEX) literature which evolved in the late 1970s claimed that government policy attempts to stimulate aggregate demand would be ineffective in real terms but highly inflationary.

It was claimed that people (you and me) anticipate everything the central bank or the fiscal authority is going to do and render it neutral in real terms (that is, policy changes do not have any real effects).

But expansionary attempts will lead to accelerating inflation because agents predict this as an outcome of the policy and build it into their own contracts.

In effect, this denies the existence of unemployment.

RATEX theory claims that individuals (you and me) essentially know the true economic model that is driving economic outcomes and make accurate predictions of these outcomes with white noise (random) errors only.

The expected value of the errors is zero so on average the prediction is accurate.

Everyone is assumed to act in this way and have this capacity.

We understand mainstream economic theory of inflation (in this case the quantity theory of money) and if governments try to trick us with higher deficits into believing there will be lower unemployment then we will act to thwart that attempt by demanding higher wages and firms will just put up prices.

So “pre-announced” policy expansions or contractions will have no effect on the real economy.

For example, if the government announces it will be expanding the deficit and adding new high powered money, we will also assume immediately that it will be inflationary and will not alter our real demands or supply (so real outcomes remain fixed).

Our response will be to simply increase the value of all nominal contracts and thus generate the inflation we predict via our expectations.

These geniuses thought this was a devastating critique against government intervention.

They formed a cult around the leaders (Sargent, Lucas, Wallace etc) and were as smug as pie at the time (early 1980s). I was a graduate student then and all these conservative wannabee PhD students would walk around with Sargent’s 1980 book on Macroeconomics and think they had found god.

It taught me about Groupthink even before I knew what it was.

The point is that the introduction of rational expectations eliminated the short-run trade-off that Friedman has originally posited.

In the RATEX world, we anticipate immediately future implications and act accordingly.

So the Phillips curve became vertical, immediately.

This sort of reasoning is still part of the core New Keynesian macroeconomics.

There is some allowance for short-run rigidities (wage rigidity) that allow some trade-off but the long-run models all argue that fiscal policy just creates inflation and real output always adjusts to the level consistent with the natural rate of unemployment.

That is the mainstream belief.

So the paper by Jeremy B. Rudd from the Federal Reserve that debunks this nonsense is an interesting development to say the least.

He makes the point in his opening that:

Mainstream economics is replete with ideas that “everyone knows” to be true, but that are actually arrant nonsense

That was a pretty good start.

He argues that – mainstream theories of aggregate supply, natural rates and household consumption choices (downward sloping demand curves) – are examples, and, “None of these propositions has any sort of empirical foundation; moreover, each one turns out to be seriously deficient on theoretical grounds.”

He believes these nonsensical ideas have led to poor policy decisions, which, in my words, have undermined the prosperity of millions of people in the world.

His target in the paper though is the proposition that:

… expectations … [are] … central to the inflation process; similarly, many central banks consider “anchoring” or “managing” the public’s inflation expectations to be an important policy goal or instrument.

He considers the core mainstream propositions to be “unsound” and has:

… no compelling theoretical or empirical basis and could potentially result in serious policy errors.

So he want us to abandon this core element of the mainstream framework.

What does he argue instead?

He reviews the brief history I presented above – Phillips curve, to Friedman, to RATEX.

His assessment?:

Even without appealing to empirical arguments … it is clear that none of these models makes a strong or even especially plausible theoretical case for including expected inflation in an inflation equation.

His reasons are technical and well-known in the heterodox literature.

For example, it was ridiculous to assume that workers didn’t know the impact of inflation on their purchasing power.

He also notes that there is no compelling empirical case to justify the mainstream approach.

He concludes:

… the various theoretical models that assumed a role for expected inflation tended to carry other empirical implications that were clearly at variance with the data.

I have already discussed in an earlier blog post that the fact that quits are counter-cyclical means that Friedman’s labour market dynamics could not be representative of the real world.

For the expectations process to drive the Phillips curve back to the natural rate, quits had to be pro-cyclical and explain the shifts down and up in unemployment.

Jeremy B. Rudd notes that:

… the documented empirical deficiencies of the new-Keynesian Phillips curve are legion

These include assuming that “real developments millions of years in the future have the same effect as developments today” and yield “counterfactual prediction”.

The equations used by mainstream economists to predict real world developments are mostly statistically useless – “suffer from such severe potential misspecification issues or such profound weak identification problems as to provide no evidence one way or the other regarding the importance of expectations”.

And lots more.

Jeremy B. Rudd presents an alternative explanation for the way the inflation process operates, which is very consistent with the Modern Monetary Theory (MMT) perspective.

He points to the close links between unit labour costs and price inflation.

But he also notes that the inflation trajectory in the advanced nations fell sharply (in level terms) during the 1990-91 recession, and the low inflation period that has endured since was due to this event “rather than to any “credibility” that the Fed gained as an inflation fighter following the Volcker disinflation.”

I have long argued that the 1991 recession was the end of the oil price inflation from the 1970s rather than all the hype about central bank inflation targetting.

20 years ago I wrote papers that showed the inflation trajectory was similar in all countries, irrespective of whether their central bank was targetting or not.

He also points out that the wage-price spiral has not been active since the 1990s because trade unions have been weakened and formal bargaining processes have been compromised by legislative and other changes.

I have also argued that a 1970s inflation is unlikely now for these very reasons. The institutional forces that propagated the wage-price interaction are no longer present.


In plain terms, the importance of his paper is that it makes irrelevant most of the commentary that you will read in the financial press about inflation.

At present there is constant claims from journalists and mainstream economists about the impending acceleration in inflation – and they point to all sorts of ‘expectations’ measures and proxy events – like bond yields rising etc.

When you dig deeper, you learn that most of this noise is coming from financial market economists who work for financial institutions that have bet in the futures markets on interest rates rising.

They stand to lose significant amounts if rates do not rise.

So, if they constantly rave on about inflation threats and berate central banks to push up rates in fear, then, of course they win the bets.

But if there is no real inflation trajectory emerging – bar the temporary supply issues due to the pandemic and other events (like bushfires in Australia) then central banks will wisely not be spooked into increasing rates, and the financial players then lose.

In broader terms, Jeremy B. Rudd has provided an elegant exposition of how a major part of New Keynesian macroeconomics is fiction.

There is not much left to reject!

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

This Post Has 14 Comments

  1. Well if you look at John Redwood latest article called ……

    “Why We have inflation – printing more money.”

    The Tories are pushing for a Brexit run by the City of London. The money supply should be via bank lending not larger deficits. Which should come as no surprise to anyone.

    Only 4 days earlier in his piece

    ” Wrong official forecasts produce wrong budgets”

    He was pushing to get rid of the Maastricht austerity criteria. Promote larger budget deficits.

    He is following the mantra of the Latest BIS paper. Same old same old without learning from your mistakes. Ultimately always ends up speaking out of both sides of the same mouth saying different things.

    They really struggle to connect the dots and square the circle.

  2. Bill Mitchell writes:

    “When you dig deeper, you learn that most of this noise is coming from financial market economists who work for financial institutions that have bet in the futures markets on interest rates rising.

    “They stand to lose significant amounts if rates do not rise.

    “So, if they constantly rave on about inflation threats and berate central banks to push up rates in fear, then, of course they win the bets.”

    This is a very interesting argument which I think should be explored further, especially in the U.S. context. Can you provide specific examples of (a) financial institutions betting on rising interest rates in the futures markets; and (b) such institutions’ economists stoking inflation fears and demanding higher interest rates?

  3. You can see the picture the narratives they use try to create.

    It is obvious following the conservatives thought process that it is all about tax cuts. Get rid of the fear of deficits and in Brexit UK we will cut taxes.

    The mental gymnastics they have to go through just to say – Brexit we are getting rid of the Maastricht Treaty austerity rules so we can raise the deficit via tax cuts, rather than increasing the deficit via spending increases is incredible.

    Each and every time they have to do these mental gymnastics to hide the truth on how things actually work from their voters. Who have been house trained to hate increased deficits and debt. Scream inflation at any spending increase.

    As per usual it all depends on where they implement the tax cuts. As Capitalism is built on sales. Consumers should get the tax cuts not big business. They still have the supply side shock to deal with when contemplating these things.

    Sunak does not agree. Sunak eventually under orders from the bank lobby will be a Hammond or Osborne chancellor and is having a battle with the Brexiteers within the Conservative party. As the Brexiteers try and level up.

    It always boils down to an either or, instead of look we can do both we can increase spending and cut taxes. Spending increases is not the devil.

    Will be interesting to see who wins the mental gymnastics between Boris and Sunak via this week’s Autumn statement. Between the bank lobby and the Brexiteers.

    I love Brexit. I adore it because the Conservatives now own it. No longer can they blame the BBC, NHS, commies, marxists, the EU or Labour, Liberals, or anyone else for poor economic outcomes. They own it now.

    You have large swathes of the conservative voting base turning into Trump voters cheered on by Farage. When the small C conservatives try and move away from neoliberalism and back to small C conservatism.They are being shouted down by the Hayek, Mises and Friedman brigade as being Marxists and Communists. There are real issues bubbling under the surface of the Tory base.

    The Tories are going to make a mess of Brexit. Unless the small C conservatives can win that inner battle. Which looks highly unlikely at the moment.

    The left just need to make sure they are ready to make Brexit a success. Not new Labour under Starmer a different Labour party who promise not to reverse the Brexit result. Left wing voters need to make sure that happens and they change the Labour party into what is needed. Leave them on mass at the polls if need be.

    It is so much easier to have the ability to change just one political party in your own country. Rather than be members of the EU and trying to change 28 political parties in different countries. To try and convince 28 to your point of view.

    It is going to be fascinating to watch how all this plays out over the years to come. If the far right take over England it is over for them and the Union.

  4. For those, like me, who come here not only for the applied economic expertise but also for Bill’s implied, intermittently expressed, meta-economic values, I suggest you might want to visit another Australian blog, that of Caitlin Johnstone, and read her latest post entitled “Capitalism is Violence.” What she lacks in economic expertise, she more than makes up for, I submit, in ethical passion and prophetic insight. For quite some time, I’ve been trying to talk about MMT in the comment section of her blog, and it would be nice to have others, more knowledgeable than I am, chime in.

  5. Looking forward to the aussie CPI numbers later this morning – consensus guess is 0.8% for the quarter.

  6. I see this as a long over due paper from one of the main economic institutions (even though there maybe a disclaimer clause). Perhaps, they want to do away with the inflation expectations hypothesis soon?).

    However, if we were to compare publication records, be they research papers, opinion papers, speeches etc. among the MMT people at the inception few decades ago (say, from Bill, Warren, Randall and et al.), you see a big wall of literature and countless other issues on how modern monetary system really functions.

    So, from that perspective, it is nice to hear about a paper by a senior Fed research staff, which further adds to the existing MMT literature (with the nuances of specific empirical evidences).

    I could be wrong seeing it this way, but I also see that the mainstreams wall might be crumbling soon. And a new chapter will begin, perhaps by starting with curriculum redesign for all the economic degree programs around the world, which will have far reaching implications on the lives of many for the better.

  7. Looking throughout history, that government borrows money seems to be central lie of the ages.

    It seems to have started with foundation of first central banks circa 1690’s, that the government borrows money and hence, has to pay interest, seems to have been perfect justification for paying money to those who already had money. In england there was “Glorious Revolution” in 1688 where parliament took power to issue money from King and founded Bank of England. Im sure parlamentarians were those who benefited from government paying interest to moneyholders and from earliest point on this lie seems to have been central justification. That’s a 333 year old lie by now.

  8. And history books are full of this crap how they “could not balance the budget” or “could not raise enough taxes”, they knew exactly what they were doing! They were issuing more money to (mostly) themselves.

  9. @Hepion,
    Those are very apt and interesting ideas.
    However, as long as the nation was on the gold standard, the nation would have to issue paper money for its deficit spending, if it didn’t borrow gold from someone to spend.

    So, borrowing gold to spend and replacing it with bonds that could not be converted back into gold on demand; did have a purpose. That purpose was to make it impossible for the holders of paper money [standing in for gold] to bankrupt the nation by having a run on the gold supply.

    This is why MMters make such a big deal out of the US leaving the gold standard in 1971. This is because after ’71 nobody could make a run on the US’s gold supply. BTW, it also makes the US gold supply without any use. Except maybe to give the people false confidence that the money has some real value.

  10. I imagine economists, are secretly studying Bill’s blog and MMT research papers, but, not surprisingly, are too embarassed to give credit where credit is due; pun intended.

    Thank God for Bill, and this blog.

  11. @Steve_American
    From what I understand, gold was mostly used for foreign trade. Traders could exchange their money to the gold, sail with gold to a foreign land, and exchange it for foreign currency. How else you could exchange currencies in time before computers?

    Now if gold were available from one gold/money exchange office for this purpose, demand for gold would depend on the needs of foreign trade, quite a miniscule component of overall economic activity. I’m not sure how constraining it was for issuance of paper money. Anyway it was completely voluntary.

  12. Two things. 1] Learn to avoid using pronouns. Replace them with nouns. Here I guess that you mean that backing the paper money with gold was completely voluntary.
    2] We know that because we have seen the 50 years since 1971 not lead to disaster. Back then they didn’t know what we know. Yes, some people thought it would be fine, but they were a tiny minority. Back in 1694, gold was money and paper money was suspect.
    And, gold coins were still being minted and used in the economy.

  13. IIRC, gold coins were in common use in the American economy until, at least, the Civil War.

  14. But gold coins were never used for the actual value of the gold in coins, gold was just the metal money was stamped on. IE they were used for monetary value, just like paper money.

    And if you could exchange your money for gold bullion at fixed price, well money is infinitely more useful as it is used as medium of exchange, so I don’t there ever was much demand to hold gold instead of money.

    This is my english skill, you have to deal with that.

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