The Theory of Reflexivity, often used in the context of economics and financial markets, implies that investors don’t base their decisions on reality but on their perceptions of reality. This creates a feedback loop where investors’ perceptions influence economic fundamentals, which in turn alter investor perceptions.
Watch the above video as Straight Arrow News contributor Larry Lindsey explains the Theory of Reflexivity in the context of current inflation challenges and argues that Fed Chair Jerome Powell should consider it when fixing monetary policy.
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The following is an excerpt from the above video:
Well, we have a great example of reflexivity that’s going on now and that’s actually part of causing inflation. At the end of last year, Chairman Powell and other members of the Federal Reserve Board said that they were thinking about cutting rates in 2024. The markets went ecstatic. They said, “Oh, they’re going to cut them seven times.” Well, that’s probably never going to happen. But anyway, that was a strong signal of rate cuts.
Now, it was not any irrational decision. If you looked at what was happening, for example, that prints for the producer price index were coming in at 0.2% a month, which is pretty consistent with where the Fed wants to go. The CPI at the end of last year was running at just 1.9%, which was at the Fed’s target. So Powell said, “Oh, we’re going to cut rates.” Well guess what happened immediately thereafter, literally, starting in January, when he sent the signal in November and December? Inflation soared. The producer price index every month went from .2% to .4%. The consumer price index went from 1.9% at the end of last year to 4.4% in the first four months of this year. That’s quite a change.
Now, did the Fed simply saying something, did that cause the inflation? Well, here you go back to the question of what is causal. Someone just saying something doesn’t cause inflation. But as in reflexivity, it causes other reactions and the cause and effect gets mixed up.