Inflation Will Be Exactly What People Expect It to Be

Sometimes yesterday’s crazy idea turns out to be sane or even essential. For instance, Fischer Black, the late finance economist and co-discoverer of modern options pricing theory, argued that the rate of price inflation will be whatever we think it will be.

If expectations are that inflation will be high, it will be high. If expectations are that inflation will be low, it will be low. For Black, who died in 1995, this was always true, at least for modern economies.

I never agreed with Black on this point, but increasingly I have begun to wonder if he wasn’t on to something. Plenty of people like to say that they knew at the time that the big money supply increases of 2008-2009 were not going to lead to high inflation. There are also people who like to say that they knew at the time that the combined monetary and fiscal response from the pandemic would lead to much higher rates of price inflation. But relatively few people can gloat about getting it right both times.

In Black’s view of the world, if people expected inflation to be high, they would spend and borrow more. Banks would create the money for this process to be self-sustaining. Under this framework, Black might have argued that no major inflation resulted after 2008 because Americans simply were not bullish enough, given the recent financial trauma.