Heterogeneous inflation expectations and aggregate implications
In this paper Pedemonte et al. explore how individuals’ experience with inflation influence their inflation expectations and the broader macroeconomic implications of this heterogeneity. Their main findings include:
Heterogeneity in Inflation Expectations:
- Inflation expectations vary significantly across different cohorts, primarily influenced by their past experiences with inflation.
- Older cohorts, who experienced high inflation in the 60s, 70s, and early 80s, tend to have higher inflation expectations compared to younger cohorts who have mostly experienced low and stable inflation.
Diagnostic Expectations-Augmented Kalman Filter:
- The authors propose a model where consumers form inflation expectations based on a combination of current information and their past experiences.
- This model, which incorporates a diagnostic expectations-augmented Kalman filter, successfully replicates the observed heterogeneity in inflation expectations across different cohorts.
Macroeconomic Implications:
- Introducing heterogeneous inflation expectations into a New Keynesian model shows that these expectations anchor aggregate responses to agents’ memories, making economic shocks more persistent.
- The persistence of shocks is due to the long memory of agents, who incorporate past high-inflation episodes into their future expectations.
Policy Implications:
- The findings suggest that central banks need to be more proactive in managing inflation expectations, especially after high-inflation episodes, to prevent these from becoming entrenched in the public’s memory.
- An active monetary policy response is necessary to mitigate the long-term effects of inflation shocks and to prevent higher future inflation expectations.
Empirical Validation:
- The paper validates its findings using detailed micro-level data from the US and international sources, confirming that past inflation experiences significantly influence individual inflation expectations.
- The model’s predictions align closely with survey data on inflation expectations, demonstrating its robustness.
Aggregate Implications of Heterogeneous Inflation Expectations: The Role of Individual Experience
Authors: Mathieu O. Pedemonte, Hiroshi Toma, Esteban Verdugo
From: Federal Reserve Bank of Cleveland, University of Michigan
Experience-based inflation expectations and the secular dynamics of real interest rates
In this paper, Stefan Nagel, explores the relationship between real interest rates and long-run inflation expectations formed through adaptive learning from past inflation experiences. Here are the main findings:
- Experience-Based Inflation Expectations: The paper posits that individuals form long-run inflation expectations based on their lifetime experiences of inflation, with more recent experiences having a greater impact. This adaptive learning model explains persistent and slow-moving long-run inflation expectations.
- Monetary Policy Response: Central banks must adopt persistently hawkish or dovish policies to align realized inflation with their targets, as private-sector agents do not anticipate future reversion of inflation towards the central bank’s target. This results in a strong positive relationship between experience-based long-run inflation expectations and real interest rates.
- Secular Variation in Real Interest Rates: The interaction between monetary policy and adaptive learning from inflation experiences generates significant secular variation in real interest rates, distinct from the natural rate of interest. This variation is evident in the U.S., Germany, U.K., and Japan.
- Empirical Evidence: The paper updates the empirical analysis of Malmendier and Nagel (2016) and finds that the learning-from-experience model continues to explain differences in inflation expectations across cohorts. Older individuals, who experienced high inflation in the 1970s, have higher inflation expectations than younger individuals.
- Model Predictions: A New Keynesian model incorporating experience-based long-run inflation expectations shows that real interest rates rise with long-run inflation expectations. The public perceives these real rates as extremely persistent, leading to similar responses in both short-term and long-term real rates.
- International Evidence: The findings are consistent across advanced economies, with experience-based long-term inflation expectations explaining a significant portion of the secular dynamics in real interest rates.
- Policy Implications: The paper suggests that central banks can only influence long-run inflation expectations through sustained periods of low inflation, rather than through policy communication alone. This has implications for how central banks should approach inflation targeting and interest rate policies.
Leaning against inflation experiences
Author: Stefan Nagel
From: University of Chicago
