What Can We Learn About Expectations from the Recent Monetary Experience?

1. Introduction " ...each man possesses opinions about the future, which go by the general name of expectations... " (Plato, Laws 644c, 360 BC) Human behaviour is determined by expectations of future outcomes. While monetary policy discussions have focused almost exclusively on expectations about future inflation, the economic behaviour of households and businesses is driven by expectations about the future outcomes for numerous other variables, such as wage and employment prospects, taxes, financial market conditions, the value of their investments, asset prices and various other economic variables that may affect their well-being. However, even for inflation expectations, which have been the subject of extensive research, economists still struggle to convincingly explain how agents form their expectations in the real world. 2. In that sense, the recent years may provide useful observations about expectations formation. With respect to inflation, after a sustained period of price stability, the last three years has seen surging inflation and rapid economic growth followed by the current sharp reversal in both growth and inflation. Similarly, large capital flows and consequential changes in monetary conditions have had a significant impact on exchange rates and asset prices. The 1997-98 Asian financial crisis and the current financial crisis in the developed financial markets also had their roots in the expectations of economic agents, especially about future risks and rewards. 3. This paper looks at the recent monetary experience, not just in Malaysia, but also in other emerging and developed economies, with a view of bringing out a number of observations about expectations formation, not just of inflation, but also of asset prices and exchange rates. With the emerging market context at least, it is my view that central banks need to be concerned not only about inflation expectations but also expectations about asset prices and the exchange rate, as these too have the potential to impact macroeconomic conditions. 3 2. Expectations about Inflation 2.1. Non-homogenous and sticky 3. Despite the general assumption in many macroeconomic models that agents form their expectation in a rational manner, anyone who has looked at survey data on expectations can attest to the significant divergence of the evidence from the rational expectations assumption. Research in this area highlights two main properties about agents' expectation formation. First, agents' expectation formation behaviour is not uniform, or in other words, expectations are formed in a heterogeneous manner. Second, in forming their expectations, agents do not update their …