Expectations, money, and the forecasting of inflation

Forecasting Inflation

What are the consequences of our perma-
nent money-price relation for the prediction of
inflation? Normally analysts use current and
past data in forecasting future prices and thus
inflation—because, after all, expectations are
not directly observable. In our view, however,
prices do not respond directly to actual money,
but only to individuals’ perceptions of perma-
nent money.

Nonetheless, current and past money data
may be useful in predicting inflation, because
individuals normally use such data in forecast-
ing future money and thus in assessing per-
manent money. Relations between inflation and
current and past money growth, such as (Γ),
then reflect individuals’ perceptions of how ob-
served money changes relate to future, and
therefore permanent, money. In other words,
an inflation forecaster must “predict” individu-
als’ perceptions of permanent money, and in
particular determine how individuals use cur-
rent and past money in anticipating future
money.

In practice, we are not likely to know exactly
how individuals calculate permanent money.
However, individuals are likely to learn, by
observation, how a particular monetary policy
operates—provided it has been followed for a
long-enough period of time—and thus their
forecasts of future money will tend to reflect the
way money has actually behaved. Analysts can
follow the same thought processes, and thus
can estimate what individuals’ expectations
will be in the context of any specific monetary
policy.

The impact of past money on inflation ac-
cordingly reflects the way in which permanent
money is calculated. This conclusion has im-
portant consequences for the relations we have
used to forecast prices. If our view is correct,
the long-run impact of money on prices appar-
ent from these relations will not generally be
unity (even assuming that money is neutral);
rather the measured impact will be that of
current money on permanent money.²² Impos-
ing the constraint of unity could lead to mis-
leading inflation forecasts except under certain
limited policy conditions. In contrast, our ap-
proach could provide a possible explanation of
the changes in the impact of money on prices
observed between the 1960’s and 1970’s (Table
1)∙

Consider, for example, a situation where in-
dividuals know that the monetary authorities
have adopted a certain target path for money,
and also know that the authorities will correct
for deviations from the target path in the pe-
riod following any such misses (Figure 1, Case
1). Changes in money that bring its level above
or below the target path are then transient;
that is, they exert virtually no impact on per-
manent money. Indeed, individuals in any pe-
riod will expect that money will be on target
by next period. Apart from this path, current
inflation will be unrelated to past money
growth—since this provides no additional in-
formation about future money and thus very
little about permanent money—and the meas-
ured long-run impact of money on the price
level will be essentially zero.

Now consider a policy situation where
money changes are purely random. Imagine,
for example, that money growth is determined
by the spin of a roulette wheel, with money
growing by the winning number when it is red

Figure 1

Effects of a One-Percent Increase in Money
(Above Its Long-Run Average Rate)

Case 2
(Money Change
Expected to be
Sustained)

Rise by one percent

Increases by one percent

Case 3

(Money Change Expected
to be Followed by Further
Changes)

Rise by more than one
percent
Increases by more than one
percent

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