Great Expectations: Beliefs, Economics, and Monetary Policy Synopsis

Great Expectations: Beliefs, Economics, and Monetary Policy Synopsis

Anthony Santomero

Federal Reserve Bank of Philadelphia

Beliefs have a real impact on the market, according to Anthony Santomero, President of the Federal Reserve Bank of Philadelphia. What consumers and businesses believe about the economy affects such empirical phenomena as rates of production and employment as well as the accumulation of personal and national wealth.

“Belief” is represented in economic discourse by the ever present notion of “economic expectations,” a concept at the heart of every economic decision made. Individual expectations (such as whether consumers spend or save, how students spend money, the ways in which employees prepare for retirement) and business expectations (e.g., how future gains are projected, the manner in which capital budgeting is planned, the way in which management sees a firm’s value proposition, views on future currency values and exchange rates) play an integral role in determining larger market patterns.

Economic expectations also figure in policy-making. For example, it has been argued in the current debate over tax cuts that proposing long-term cuts may best promote spending because consumers believe those cuts will be long term. Transitory changes aimed at short-term economic response, on the other hand, may be more effective in the case of stimulating equipment purchase through related tax breaks that businesses believe to be only temporary.

The operations of the Federal Reserve Bank are crucial to maintaining the stability of the public’s economic expectations. Its central mandate, established by a Congressional Act of 1913, is to foster the conditions for maximum sustainable economic growth. Two critical factors in facilitating this growth are keeping inflation at a minimum through price stability and offsetting shifts in demand that defer the economy’s potential performance. It is important that the Fed establish long-term credibility in these functions in order to maximize economic expectations that are conducive to its over-arching goal of national economic growth.

Santomero compared the Fed’s poor performance in the 70s—when it failed to maintain price stability in the face of an economic downturn—to the recent success of its aggressive counter-cyclical policy, which promoted spending into the downturn and dampened the breadth and depth of this past recession.

As a discipline, economics has long studied expectations: how they are formed, how they change, their speed of adjustment, and correlations between beliefs and spending-investment patterns. The methodology of these studies includes surveys, extrapolation from past data, and economic modeling—calibrated to the past, but projected into the future.

There is increasing awareness within the field—through research and practice—that policy-makers can assist the market through transparency in public discourse. In the case of the Fed, providing explanations behind decision-making and strategic assessments of the situations in which decisions are made enhances public confidence in the Fed’s ability to achieve its goal of long-term economic stability. As such, the Fed’s practices of inflation-targeting are evolving from implicit to explicit in order to increase the efficacy of its policy.

Outlook and expectations are at the core of economics and are a self-fulfilling prophecy. Confidence leads to spending, which leads to production, which leads to jobs, and, ultimately, to economic growth. If national monetary policy hinges on confidence in the Fed to maintain price stability, then the Fed must demonstrate like stability in pursuing its objectives and communicating them to the public. Santomero concluded by emphasizing the centrality of action: doing that which creates credibility reinforces it. The Fed seeks to maintain this exemplarity in fulfilling its mandate of achieving sustained economic growth.