NEW YORK (Bloomberg) — In 1995, the Swedish Academy of Sciences awarded the Nobel Prize in economics to Robert Lucas, calling him “the economist who has had the greatest influence on macroeconomic research since 1970.”Lucas’s specific contribution was developing and applying the hypothesis of rational expectations, the idea that people make economic decisions based on previous experience and expectations about the future.

For example, if consumers expect inflation to accelerate, they will buy more today, putting additional pressure on prices. That’s why the Federal Reserve is so focused on containing inflation expectations, demonstrating its commitment to keeping prices tame by their words and deeds.

This rational expectations stuff sounds nice in theory. In practice, it seems more suited to an elite club <\m> folks who watch and analyse the Fed or trade stocks and bonds for a living <\m> than the public at large.

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.

The most popular answer to the first question on the rate of price increases was “no clue”. Some were embarrassed at their lack of knowledge (“I should have known that,” a computer programmer said before taking a stab with three percent for current and expected inflation.) Many of the clueless-on- current prices had “no idea” on future price increases either. At least their behaviour would be consistent, based on experience and expectations!

The quantitative answers on question 1 ranged from a low of “.03 to .04 percent” to 20 percent. The high bid was from a woman who said she was “a business owner for 20 years.”

Imperfect Information

It’s not so much that people outside the financial industry are poorly informed. The question is, how can we ascribe rational expectations theory to the behaviour when information is lacking?

Lucas and his cohorts put “a lot of emphasis on the benefits of information but very little on the costs of getting it,” said Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh. “There is no cost of acquiring information in their model.”

That said, it doesn’t make the role of inflation expectations “less important,” Meltzer said. “It just makes it noisy.”

Participants in my survey may not know how fast prices are rising, but most of them knew what the Fed is and how it affects inflation. At least they answered in the affirmative.

Some folks qualified their responses when asked “What is the Federal Reserve?” “The federal government?,” one driver for a moving company asked. Others got closer: “A bank,” “Money comes through the Fed and goes out to the branches,” “Alan Greenspan used to cover it,” “Money for defence”, “5.25 percent.”

At least the Fed can take comfort that it has name recognition.

Given the uninformed answers to questions one, two and three, I was impressed that a few folks had a partial grasp of the Fed’s role in inflation, my fourth question. Some of the answers — “They control the flow of money,” and “they set the interest rate on Treasury bills” — were encouraging if not entirely accurate. Others — “They regulate it” — were not.

A man who described his occupation as a “part-time distributor of fliers in the New York area,” wasn’t tuned in to inflation (“rapid: 8 to 15 percent”) or the Fed, but he had plenty of insights on the economy (“a reduction in income,” and “job losses in autos”). His flier was hawking “Psychic Prediction by Christine,” who seemed like a good candidate for my survey.

Christine was with clients, so I called the psychic hotline and got 10 minutes of clairvoyance from an “adviser” named Randa.

Randa said she saw “a bit more inflation from late July to mid-September,” levelling off until next winter’s “Great Inflation.” She saw (she said she pictured the graph) “upward motion” in the stock market during the summer time, and then a “very dramatic fall, like the one that just occurred, in late September, the first week in October <\m> something having to do with the economy.”

The economy’s “rate of growth is slowing,” she said, and “there needs to be an adjustment in the forms of employment: Health care will be “big” versus manufacturing.

Housing should be “on better footing” by next year, but with all the “alternative financing, buyers need to be more savvy.”

What more could you want? Randa sounded like an informed economic agent, someone who would make decisions based on past experience and expectations about the future, just as Lucas said.

Then again, psychics by definition can see the future. It’s the man in the street I’m worried about.Caroline Baum, author of “Just What I Said,” is a columnist for Bloomberg News. The opinions expressed are her own.