Phelps key observation in macroeconomics was that the relationship between inflation and unemployment is affected by expectations, and since expectations themselves are endogenous they change over time so, too, will the relationship between unemployment and inflation. If a government attempts to push the unemployment rate too low, inflation will increase, and so, too, will inflationary expectations.

If the BOJ were to succeed in raising inflation expectations, long term interest rates would necessarily have to reflect a correspondingly higher inflation premium. As long as nominal interest rates are rising because of inflation expectations, the increase is part of the solution, not part of the problem.

Waiting until inflation is here, as some propose, is the usual way. But that merely fuels inflation expectations and makes the task more painful.

The third argument is that higher inflation today would endanger the ECB s credibility in the future. This argument, too, is hardly irrelevant higher inflation today must not be permitted to change inflation expectations in the medium run.

Yet they do not apply the same reasoning to the decline in inflation expectations that occurred during the same period. They have followed the same logic since the purchases began, ignoring recent increases in interest rates, while lauding the small rise in inflation expectations as proof of QE s effectiveness.

Falling oil prices and the prospect of a prolonged period of low inflation also seem to have affected inflation expectations. Given the potency of the recent oil price shock, the risk is that inflation may temporarily slip into negative territory in the coming months.

In reality, of course, QE whether the expectation or execution of it would affect both interest rates, and the inflation expectations that are derived from them. So, if ECB President Mario Draghi wants to highlight the fact that nominal interest rates are lower today than last August, he must also acknowledge that, given low inflation expectations, real interest rates have moved little.

LONDON Speaking in the happier economic times of 2005, Mervyn King then, as now, Governor of the Bank of England stressed the importance of entrenching public expectations of stable, low inflation. He warned that, if you let inflation expectations drift too far away from the target, you can end up in quite serious difficulty with a costly process to bring them back again.

These shocks were naturally beyond the ECB s control. The policy response, however, required preventing these shocks from becoming entrenched in medium to long term inflation expectations.

Another problem with using the five year, five year forward rate of expected inflation to gauge QE s effectiveness is that the rate is correlated with oil prices. Indeed, when oil prices fell last year, so did inflation expectations (measured however imperfectly).

But the real fear is not inflation itself that is, that prices might rise at a surprisingly fast clip this year or next. Rather, the fear is that central banks will not see inflation coming until it is too late, and that this will cause a major upward shift in inflation expectations.

In a more global context, none of this is to dismiss the longer term dangers of inflation. In most countries, at most times, inflation should be kept very low and central banks should anchor inflation expectations with a stable long term target, although the alternative of targeting nominal GDP deserves to be discussed.

Not surprisingly, central bankers who are committed to a formal or informal inflation target of about 2 per year are unwilling to abandon their mandates openly and to assert that they are pursuing a high rate of inflation. Nevertheless, their expansionary actions have helped to raise long term inflation expectations toward the target levels.

Consumer price inflation in the eurozone has been below target for 22 consecutive months long before the price of oil started collapsing. Cheaper oil is a boon for growth but it also lowers long term inflation expectations, which are the true target of monetary policy.

When deflationary expectations are entrenched, as they are in Europe today, consumers and investors delay spending on the ground that prices and costs will be lower tomorrow. Those expectations become self fulfilling, because less spending means even less inflation and, in the worst case, falling prices.

Moreover, the stock market channel leading to asset reflation following QE works only in the short run if growth fails to recover. And the reduction in real interest rates via a rise in expected inflation when open ended QE is implemented risks eventually stoking inflation expectations.

It is nonsense to argue that central banks are impotent and completely unable to raise inflation expectations, no matter how hard they try. In the extreme, governments can appoint central bank leaders who have a long standing record of stating a tolerance for moderate inflation an exact parallel to the idea of appointing conservative central bankers as a means of combating high inflation.

The second risk is that, even based on current growth expectations, investors may have gotten ahead of themselves in anticipating monetary policy tightening. The Fed will raise interest rates when it senses that the economy is nearing full capacity and that inflation wage inflation, in particular is accelerating.

Moreover, surveys of consumer expectations show that US households expect prices to rise at more than 2 in both the coming year and the more distant future. That expected inflation rate is consistent with the difference in interest rates between ordinary US government bonds and Treasury Inflation Protected Securities.

The first knockout would occur if, in the MPC s view, it is more likely than not that CPI inflation 18 to 24 months ahead will be 0.5 percentage points or more above the 2 target. The second is that medium term inflation expectations no longer remain sufficiently well anchored.

It will reinforce convergence expectations among financial market participants, which will translate into lower risk premia for investors. Lower risk also will bring inflation expectations down and reduce interest rates, which will in turn speed up the compression of Polish government bond yields to comparable EU levels, increasing financial stability.

The second reason might be that even with anchored inflation expectations (and thus price stability), policymakers do not know how to keep them anchored while boosting the flow of spending in the economy.

All the major Western central banks including even the traditionally hawkish ECB appear to be sticking their heads in the sand. But there is something they can do to ensure the benefits of inflation targeting rules (credibility and well anchored inflation expectations) while also supporting recovery raise the stated target.

These ideas, combined with effective policy practice like that of the US Federal Reserve under Paul Volcker s chairmanship, led many countries worldwide toward more explicit inflation targeting, in which central banks stabilize inflation expectations by making a credible commitment to a predetermined rate of price growth. By the 1990 s, inflation was old news in the advanced economies, with much of the developing world soon to follow.

Third, we have little idea about how the public forms expectations about the central bank s future actions. If the Fed announces that it will tolerate 4 inflation, could the public think that the Fed is bluffing, or that, if an implicit inflation target can be broken once, it can be broken again?

Second, many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.

Phelps work helped us to understand the complexity of the relationship between inflation and unemployment, and the important role that expectations can play in that relationship. But it is a misuse of that analysis to conclude that nothing can be done about unemployment, or that monetary authorities should focus exclusively on inflation.

But this history means that the true real long term interest rate was not as high in the 1980 s as our measures show, because long term inflation expectations must have been much higher than the one year inflation rate was at the time. Holders of long term bonds, for example, must have thought that inflation would come roaring back after the effects of the 1981 2 global recession had passed.

Seminar expectations

It does not want to rush, because the US economy is still weak, with first quarter growth a lackluster 1.8 . But it cannot wait too long, lest inflation expectations drift to a dangerously high level, forcing the Fed to move aggressively  and at the cost of considerable economic pain to wring inflation out of the system.

Mind you, two years previously, at the outset of the financial crisis, I suggested raising inflation to 4 or more for a period of a few years to deflate the debt overhang and accelerate wage adjustment. But there is a world of difference between temporarily raising inflation to address a crisis and unhinging long term expectations.

It does not want to rush, because the US economy is still weak, with first quarter growth a lackluster 1.8 . But it cannot wait too long, lest inflation expectations drift to a dangerously high level, forcing the Fed to move aggressively and at the cost of considerable economic pain to wring inflation out of the system.

For example, a central bank might announce that circumstances during, say, the next two years warrant a doubling of the inflation target from the usual that is, almost never varied annual rate of 2 . Such an approach would reduce the risk of debt deflation, while capping inflation expectations to prevent a damaging surge in prices as recovery takes hold.

Still others raised concerns about expansionary fiscal and monetary policy. And some favored one set of polices (say, resolving underwater mortgages and recapitalizing the banks), while opposing all the others (for example, deficit spending and raising inflation expectations).

Goals and expectations

Goals and expectations

A growth model that applies to advanced countries may be a poor guide in developing countries. Models that emphasize expectations are sometimes best for analyzing inflation and unemployment levels at other times, models with Keynesian elements will do a superior job.

But, despite empirical refutation, the ideological attractiveness of monetarism, supported by the supposed authority of rational expectations, proved overwhelming. As a result, the purely inflation oriented approach to monetary policy gained total dominance in both central banking and academic economics.

The most important component of Abenomics this year has been the BOJ s efforts to ease monetary conditions further, despite zero interest rates, and thus end the threat of deflation. Under these circumstances, inflation expectations are not a cause for concern.

As a practical matter, even controlling for expectations (as Phelps work insists that we do), the relationship between unemployment and inflation is highly unstable. It is virtually impossible to discern the relationship from the data except in a few isolated periods.

Were your expectations met?

Some economists worry that negative second quarter data will dampen inflation expectations, thereby undermining Abe s plan for boosting growth. Meanwhile, the Bank of Japan (BOJ) is emphasizing the positive outcomes of its monetary policy and is hesitating to continue its expansionary measures.

Great Expectations for the Renminbi

The world's expectations are high.

Hence, their expectations were met.