The Permanent-Transitory Confusion: Implications for Tests of Market Efficiency and for Expected Inflation During Turbulent and Tranquil Times

Even when all past and present information is known, individuals usually remain uncertain about the permanence of observed variables. After reviewing the history and role of adaptive expectations and its statistical foundations in modeling this permanent-transitory confusion, the paper investigates the consequences of this confusion for tests of market efficiency in the treasury bill and foreign exchange markets. A central result is that the detection of serial correlation in efficiency tests based on finite samples does not necessarily imply that markets are inefficient. The second part of the paper utilizes data on Israeli inflation expectations from the capital market to estimate the implicit speed of learning about changes in inflation and to examine the performance of adaptive expectations in tracking the evolution of those expectations during the 1985 shock stabilization as well as during the stable inflation targeting period.