One need look no further than Federal Reserve Chairman Alan Greenspan's use of interest rates to manage the stock market and the economy to realize that expectations play a key role in economic well-being. In recent years, economists have learned a great deal about how interest rates can help keep inflation at bay. Now, Stanford Business School economist Peter Henry has marshaled more evidence in support of the view that expectations matter and that inflation can be successfully managed.
But it wasn't so long ago - when double-digit inflation haunted the U.S. economy in the early 1980s - that traditional economists thought that any effort to reduce inflation would inevitably cause a recession. The thinking was that if they raised interest rates in order to bring down inflation, there would be a high cost to pay in terms of slower economic growth. Companies would suffer losses; unemployment would inevitably climb; recession would loom.
In contrast to that traditional view, some economists have argued that inflation can be reduced with minimal short-term costs if policymakers are able to change the public's expectations about inflation. If policymakers credibly commit to reducing inflation, the public will believe them and inflation will fall without a dramatic slowing of the economy. Post-World War I Europe offers case studies of countries that abruptly halted enormous inflation rates at virtually no cost to output because government policies firmly set expectations. Other studies have shown that a number of emerging economies even experienced economic booms while trying to squelch high inflation.
So, which perspective is correct? According to Henry, an associate professor of economics, neither view asks the most important question: Do the long-term benefits of reducing inflation outweigh the short-term costs? Economists have been so focused on measuring the costs that they have not asked whether the gain that results from lower inflation justifies the pain required to reduce it. Henry uses the stock market to gauge the net effects.
In a well-functioning and rational stock market, he points out, changes in stock prices reflect revised expectations about both future corporate profits and interest rates. Measures taken to stabilize inflation may raise interest rates and reduce profits in the short run-which is bad for the stock market. However, the reduction in inflation may increase future profits and reduce interest rates - which is good for the market. Therefore, the stock market response to the announcement of a policy directed at reducing inflation measures whether the good effects of reducing inflation outweigh the bad.
Henry constructed a database of 81 different episodes of inflation in 21 emerging economies, such as Chile, Argentina, Indonesia, and Mexico, over a 20-year period ending in 1995. He identified 25 episodes where inflation was greater than 40 percent. The median inflation rate among those episodes was 118 percent. In the moderate group of inflation episodes he examined, the median rate was 15 percent.
Henry found that when countries tried to stabilize high inflation, the stock market increased by 24 percent on average. In other words, reducing high inflation has a large positive effect on the stock market. In contrast, he discovered that reducing moderate inflation had no significant effect on the stock market. He also found that the stock market's response to attempted inflation-stabilization is a reliable predictor of future changes in inflation and economic growth. In other words, a positive stock market response to inflation stabilization predicts lower inflation and faster economic growth in the future and vice versa.
The United States does not suffer the walloping inflation rates that plague emerging markets. So, does Henry's work have any relevance to the U.S. economy? "What this research suggests is that there really is something to the story that expectations matter a lot," says Henry, noting that at the moment managing stock market expectations seems to be an important part of managing the American economy. The most dramatic cases of expectation-setting, however, are in emerging economies. For example, inflation spiked at 344 percent in Peru in 1989. The following year a new government was elected, new policies were announced, and inflation plummeted to 44 percent by 1991. Real GDP picked up 6.7 percent.
In addition, Henry says, "This research demonstrates that reducing high inflation has different implications for the economy than reducing moderate inflation. People seem to believe that there will be large long-run benefits of reducing high inflation and virtually no short-run costs. With respect to reducing moderate inflation, the expectation seems to be that the benefits will not outweigh the costs."
Overall, he says, "The results provide important new evidence that high inflation and moderate inflation present very different policy challenges. More generally, it suggests that there is much valuable information to be learned by carefully studying the interaction of the stock market and the real economy." Indeed, the National Science Foundation recently gave Henry a five-year, $250,000 award to support more of his research on the financial and economic effects of policy reform in emerging markets.