How ignorance of economic reality can undermine policy

A study has found many Kiwi business owners lack understanding of inflation rates or the role of the central bank. Photo / iStock

One of the key missions of the world's central banks is to guard against dramatic movements in the price of goods. It's a job that's as much about psychology as it is economics: Public confidence in central banks to maintain stable inflation actually helps keep prices in check. Or so the thinking goes.

Now, a new paper, led by Saten Kumar of Auckland University of Technology, finds that many businesses in New Zealand do not have a clear understanding of inflation rates, much less the role of the central bank. Nor do they show much interest in learning about it: Google searches for puppies, the paper points out, are consistently more popular than searches for economic data.

That disconnect between popular perception and economic reality can wind up undermining the power of monetary policy, the paper argues.

New Zealand is a particularly useful case study. The country adopted an explicit goal for inflation 25 years ago, making it a pioneer of so-called "inflation targeting". The practice is now standard at central banks around the world, including the Federal Reserve, with the target typically set at 2 percent.

The move is intended to let the public know that the central bank will work hard to ensure prices do not veer too far from the desired level. Businesses will then make long-term plans based on that rate of inflation, which in turn helps assure that prices remain stable, creating a positive feedback loop.

At least, that's how it works in theory. Kumar and his coauthors conducted detailed surveys of firms in New Zealand showing how that assumption breaks down.

About 20 per cent of businesses forecast that inflation over the next five to 10 years would align with the New Zealand central bank's target of 2 per cent. But just as many believed inflation would be 5 per cent — more than double the central bank's goal. And another 20 per cent predicted inflation would be between five and 10 per cent.

The results could be a sign that firms don't trust the central bank to hit its inflation target. But more likely, the authors write, it's a sign that they don't really understand what it all means — whether in New Zealand or in the United States.

So where does that leave central banks reliant on accurate public expectations of inflation in order to do their job?

"The fact that the public may largely be unaware of the policies or of their implications for aggregate prices implies that their effects will most likely be limited, or at least less than predicted by models with full information rational expectations agents," the authors write.

The authors say the knowledge gap is an opportunity for the world's central banks. The Fed in particular has made a concerted effort to increase transparency and communication with Main Street. Other studies have found that businesses that are given information about the central bank's inflation target tend to revise their forecasts to match that target.

"This suggests that if central banks can more successfully communicate their objectives to the broader public, then this should have a pronounced effect on the beliefs of individuals," the paper states.

Kumar's coauthors are Hassan Afrouzi and Olivier Coibion of University of Texas at Austin and Yuriy Gorodnichenko of University of California at Berkeley.