What data on expectations reveal about future inflation?
Ricardo Reis explores the importance of expectations in predicting future inflation:
Inflation has an anchor in people’s expectation of what its long-run value will be. If expectations persistently change, then the anchor is adrift; if they differ from the central bank’s target, the anchor is lost. This paper uses data on expectations from market prices, from professional surveys, and from the cross-sectional distribution of household surveys to measure shifts in this anchor. Its main application is to the US Great Inflation. The data suggests that the anchor started drifting as early as 1967 and that this could have been spotted well before policymakers did.
What do inflation expectations reveal about inflation today?
It is the household survey that is more worrying as both the long-horizon expectations and the one-year ahead have jumped up in just 6 months faster than almost ever before in the post-1980s sample. This implies that few US households believe today that inflation will be below target in the near future, and just as many expect that an inflation disaster could happen.
Losing the Inflation Anchor
Author: Ricardo Reis
From: LSE
Do inflation expectations really matter?
The importance of inflation expectations cannot be supported neither theoretically nor empirically, argues Jeremy Rudd in this paper.
From a theoretic point of view, inflation expectations were incorporated in models such as those developed by Phelps, Friedman, and Lucas, along with the more-recent new-Keynesian Phillips curve. But, Rudd argues:
- Both the Phelps and Friedman assumptions can be viewed as trying to ensure that money illusion is absent, that purely nominal disturbances cannot have permanent real effects on the economy, or both.
- As for the Lucas model its prediction that only random and transitory policy shocks can affect output seems unappealing on a priori grounds. Finally, the channel through which expected inflation enters the new-Keynesian Phillips curve is especially contrived. In the canonical version of these models, the nature of the contracting mechanism is such that producers are required to supply as much output as is demanded at the fixed contract price. Given the imperfectly competitive market structure of these models, firms are therefore concerned with their current and expected real (that is, relative) price, since a future decline in their relative price will result in additional demand that could be less profitable to meet at the previously contracted nominal price. When these individual pricing decisions are aggregated, the result is a dependence of current economywide inflation on expected future inflation.
Another possible explanation?
[A]n important feature of inflation dynamics after the mid1990s appears to be the lack of a strong wage–price spiral (or of any significant year-to-year feedback between wage growth and inflation). This is true despite large (but ultimately transitory) increases in actual inflation—for example, headline PCE inflation averaged 3 percent over the three years leading up to the 2007–2009 recession.27 It seems unlikely that well-anchored long run inflation expectations were the root cause of this stability, inasmuch as this belief also leads to the conclusion that workers were willing to ignore noticeable (and reasonably sustained) changes in the cost of living when deciding on the wage rate that they were willing to accept, simply because they believed that eventually inflation would return to some long-run average pace.
Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)
Author: Jeremy B. Rudd
From: Federal Reserve Board
