Thursday, March 15, 2007

Interesting Article

This bloomberg article describes the counter-intuitive result of rational expectations (the theory that the market is forward looking).

Here is her argument

I decided to test my hunch that expectations aren't always rational or even informed by hard knowledge. My simple survey consisted of four questions designed to determine the public's inflation expectations and the Fed's credibility. I posed four questions to 40 randomly selected people near Bloomberg's world headquarters at Lexington Avenue and 59th Street in New York:
1) What is the current rate of inflation or, in response to a blank stare, how fast are prices rising?
2) What is your expectation for economy-wide prices over the next 12 months?
3) Do you know what the Federal Reserve is?
4) Do you know how the Fed affects inflation?
I don't pretend that my survey was in any way scientific or conclusive. It was eye-opening, to say the least. When one considers the territory (a high-rent district) and sample selection (I avoided people who looked as if they were more interested in picking my pocket while I was picking their brain), the results were even more discouraging than I imagined.

I have a couple of follow up questions

1) What is the price of gasoline? If you don't know the precise number, has it been going up or down over the past 2 weeks?

2) How much do you spend on your food bill at the supermarket? Has it been stable? If you don't actually pay for your food, ask your parents or whoever else does.

3) For those flat screen freaks like me, how much on average is a 40-42 inch LCD 720p TV? For the mall rats, how much is a pair of Gap pants or (for the girls) express sweaters?

Chances are you either know the answer to these questions or, if you don't, you aren't interested in these markets. But I would bet a couple of bucks that for the markets you do follow (gas), you know the basics. You don't have to know who runs the Federal Reserve to be rational on the prices that pertain to your life. In fact, given the way the Fed has operated over the past 20 years, you probably don't really need to be following Bernanke's every move.

Further, you don't have to accept rational expectations completely. You can be the type of economist who believes that portions of the markets (Financial markets, for instance) are fairly forward looking while the consumer market (goods market) is more adaptive (that is, changes their expectations in respose to stuff that already happened).

But as the author said, her study was not scientific.

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