Expectations and monetary policy

Market-based vs survey-based inflation measures

Why do markets and people differ in the first place and what does this tell us about how expectations are formed and how policy affects the economy? To answer this question, Ricardo Reis in this paper introduces a new variable the “discrepancy”: defined as the business-cycle dynamics of the discrepancy between market and survey measures of long-run inflation expectations.  This variable has three characteristics: a) it concentrates on long-horizon inflation expectations, averaged over 5 or 10 years out; b) it measures their fluctuations at a business-cycle frequency; c) it focuses on why two legitimate ways to measure expectations, surveys of people, or prices of assets, give very different estimates. He then uses a model that builds on some of the leading behavioral theories of expectations, and fits the data exactly, with a minimal number of free parameters. The model’s inputs are asset prices and cross-sectional moments from surveys, and it provides both a decomposition of the discrepancy, as well as a measure of the underlying rational expectation of inflation that is the anchor for inflation dynamics.

Applying the model to US data he finds that long-run inflation expectations have not been anchored in the US. In particular, they have been steadily declining from 2.0% to around 1.8% between 2014 and 2019.

The People versus the Markets: A Parsimonious Model of Inflation Expectations
Author: Ricardo Reis
From: LSE

How to manage expectations

In order to anchor expectations should the central bank, in its communications, focus on the level of the policy instrument i.e. the interest rate, or emphasize the policy outcome i.e. the level of unemployment. This is a particularly prescient issue during unprecedented crises such as COVID-19 when people may have difficulty reasoning about the economy. In this paper, Angeletos and Sastry argue that in circumstances where people have distorted beliefs about the behavior of others the optimal communication strategy switches from anchoring expectations of instruments to anchoring expectations of targets like employment or income.

Why? Instrument-focused communication leaves the public to reason about the effect of interest rates on aggregate employment and income. Target-focused communication does the opposite, sacrificing clarity about the policy for more anchoring of the expectations of targeted outcome. A larger [general equilibrium] GE multiplier makes expectations of aggregate outcomes such as employment and income more essential for private decisions, and any mistakes thereof more detrimental for welfare, which tilts the balance toward target focused communication.

Managing Expectations: Instruments vs. Targets
Authors: George-Marios Angeletos, Karthik A. Sastry
From: MIT