Learning about inflation expectations from the data

Francesco D'Acunto, Ulrike Malmendier, Michael Weber 07 May 2022

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Inflation has been surging to historical levels around the globe. Should central banks raise interest rates aggressively in line with the traditional policy responses to fight surging inflation (e.g. D’Acunto and Weber 2022)? And how can central banks be effective in communicating their inflation outlook and policy responses when facing ordinary consumers and firms who mostly lack economic and financial literacy? The answers to these questions, and the general overarching theme of how central banks might anchor expectations in times of heightened inflation, require a deep understanding of how consumers form and update their inflation expectations. Contrary to the assumptions of virtually any model used in central banks, ordinary consumers often do not adhere to the paradigm of full-information rational expectations but rely on rules of thumb and narratives to form economic beliefs, which are often provided by non-expert sources (Andre et al. 2021). 

Subjective expectations are not only important in times of high inflation. In fact, they are a key determinant of virtually any intertemporal consumption and investment decisions households and firms make. In particular, according to economic theory, inflation expectations play a special role because of the relationship between perceived real interest rates and consumption (consumer Euler equation): based on this relationship, in times of high inflation, consumers perceive lower real rates (Fisher equation) and hence savings for future consumption becomes less worthwhile, leading to higher current consumption. Inflation expectations also drive agents' wage bargaining choices, as well as the choices to invest in durable goods, such as houses and cars, and shape individuals’ decisions on how to finance such investments (Bernanke 2007, Botsch and Malmendier 2021). Because inflation expectations drive the decisions and actions of many economic actors, they also affect aggregate economic outcomes and realised inflation. 

Needless to say, because inflation expectations play such a central role for individual choices and hence aggregate outcomes, central banks around the world regularly and actively attempt to manage consumers’ inflation expectations. In normal times, when no constraints on nominal policy rates bind, many central banks operate under the assumption that inflation expectations are well-anchored and that changes in nominal policy rates transmit one-for-one to perceived real interest rates (Coibion et al. 2022a, 2022b). But managing inflation expectations becomes even more important in times when an effective lower bound on the nominal policy rate binds, because it remains one of the only policy tools available to central banks to affect agents' perceived real interest rates and hence their consumption, saving, and investment decisions (D’Acunto et al. 2022a).

Surprisingly, despite the ubiquitous role of inflation expectations in households' choices and hence aggregate outcomes, economists and central bankers still lack a deep understanding of how such expectations are formed, updated over time, and how they transmit into economic decisions. Indeed, the rational-expectations revolution of the 1970s drastically reduced the interest of academic economists in studying actual expectations because according to this paradigm, the economic model implies the representative agent's expectations directly. The full information rational expectations (FIRE) version of this framework does not even have any scope for heterogeneity and dispersion in subjective expectations of different economic agents. 

These theoretical predictions stand in stark contrast to a growing literature documenting systematic deviations of consumers’ inflation expectations from the FIRE paradigm, which we review in a recent survey of this literature (D’Acunto et al. 2022). For instance, average households' inflation expectations across countries and time periods are systematically biased upward relative to the ex-post realised inflation rates and the inflation rates that central banks target. Moreover, forecast errors are predictable by publicly available data (Coibion and Gorodnichenko 2015). 

Moreover, the dispersion in inflation expectations across households is substantial – a feature of real-world inflation expectations that, as we discussed above, the FIRE paradigm cannot account for by construction. What’s more, the heterogeneity of inflation expectations does not appear due to noise in the elicitation of subjective beliefs, because the literature has documented systematic regularities and correlations of heterogeneous inflation expectations with consumers’ demographic characteristics and economic environments.

Figure 1 plots the distribution of US households' 12-month-ahead numerical inflation expectations. We focus on the mean of the subjective distribution for the inflation rate over the following 12 months.

Figure 1 Mean and percentiles of 12 month-ahead expected inflation

Households' inflation expectations are substantially higher than the inflation expectations of financial market participants (unreported), and this phenomenon is not driven by outliers who report implausibly high values. Rather, most of the distribution of households’ inflation expectations lies above the one-year-ahead inflation expectations of market participants. Moreover, the distribution of households' inflation expectations is systematically skewed with the mean monthly expected inflation rate being about one percentage point higher than the median. This skewness suggests that some households hold inflation expectations that are substantially higher than those of others and stresses the importance of understanding the determinants of households' expectations and identifying the characteristics and demographic groups that might drive this phenomenon. Furthermore, in times of relatively stable economic conditions, such as the months between June 2013 and early 2020, households across the distribution reported changes in inflation expectations that were directionally similar from one month to the other. In times of large economic shocks, instead, such as the onset of the Covid-19 pandemic in February and March 2020, we observe substantial disagreement across households about the future evolution of inflation. 

So which consumer characteristics help explain heterogeneous inflation expectations? For instance, women on average have systematically higher inflation expectations than men (D’Acunto et al. 2021a). Also, younger individuals have lower inflation expectations than older individuals (Malmendier and Nagel 2016). And consumers with lower socioeconomic status – the combination of income and education levels – also tend to have higher inflation expectations (Das et al. 2020). Research also shows that individuals with lower cognitive abilities — after controlling for their education and income levels – have higher expected inflation rates than others (D’Acunto et al. 2019, 2022a). And minority consumers tend to have higher expected inflation rates than White consumers. 

But then what explains this systematic heterogeneity in inflation expectations across demographic groups? Differences in the actual price changes consumers observe in their daily activities and economic environments seem to play an important role (D’Acunto et al. 2021b, Weber et al. 2022). Lucas (1975) might have provided a closer description of reality than he anticipated when writing that, “the history of prices […] observed by an individual is his source of information on the current state of the economy and […] of information on future price.” As it turns out, consumers do rely on prices they personally face in their daily lives to form expectations about aggregate inflation rather than simply looking up inflation statistics. 

In D’Acunto et al. (2021b), we find households that witnessed the highest realised inflation in their grocery bundle over the previous 12 months have on average inflation expectations that are about 0.45 percentage points higher than the expectations of households with the lowest realised inflation rates. Furthermore, measures of realised inflation that overweigh goods households purchase frequently and measures that overweigh positive price changes drive the baseline association between realised inflation and inflation expectations at the household level. Other determinants of price changes such as their volatility, more recent price changes, the occurrence of sales, or alternative weighting schemes do not provide additional explanatory power above and beyond the price changes of frequently purchased goods. These associations hold up in within-individual analyses and hence cannot be driven by time-invariant individual characteristics, such as education levels or social background and upbringing.

As we discussed early on, systematic biases and heterogeneity in inflation expectations matter for aggregate outcomes and hence policymaking if consumers do follow on and make choices based on their inflation expectations. Armantier et al. (2015) are among the first to show that many consumers behave in line with their subjective inflation expectations when choices are financially incentivised. For field evidence, using expectations data and spending plans from the European Commission Consumer Survey, D’Acunto et al (2018, 2022a) find strong economic and statistical evidence that consumers who expect higher inflation over the following 12 months have a higher propensity to purchase durable goods. These findings have been confirmed using US data from randomised information provision experiments (Coibion et al. 2022a). Moreover, Fermand et al. (2020) show that not only the estimated level of inflation affects choices but also the uncertainty in households’ subjective inflation expectations. 

Research so far has only scratched the surface of our understanding of how inflation expectations are formed and updated and the ways in which they matter for aggregate outcomes and economic policy. Much more research is needed at the descriptive level in terms of understanding which biases and systematic sources of heterogeneity survive across economies and over time as well as how existing leading macroeconomic models can incorporate heterogeneous and biased inflation expectations to obtain richer predictions that, thanks to the increasing availability of data on subjective inflation expectations across countries, can now be brought to the data. Moreover, more work is needed linking inflation expectations to economic decisions (Roth and Wohlfart 2020), including mortgage and housing choice (Malmendier and Steiny 2021). It is an exciting time to study subjective inflation expectations, their relevance for individual and aggregate outcomes, and how policymakers can win the challenge of managing them despite their heterogeneity (D’Acunto et al. 2022b, 2022c). 

References

Andre, P, I Haaland, C Roth and J Wohlfart (2021), “Inflation narratives”, VoxEU.org, 23 December.

Armantier, O, W Bruine de Bruin, G Topa, W van der Klaauw and B Zafar (2015), “Inflation Expectations and Behavior: Do Survey Respondents Act on their Beliefs?”, International Economic Review 56(2): 505-536. 

Bernanke, B (2007), “Inflation expectations and inflation forecasting”, Technical report, Board of Governors of the Federal Reserve System (US).

Botsch, M J and U Malmendier (2021), “The long shadows of the great inflation: Evidence from residential mortgages”, Manuscript.

Coibion, O and Y Gorodnichenko (2015), “Information rigidity and the expectations formation process: A simple framework and new facts”, American Economic Review 105(8): 2644–2678.

Coibion, O, Y Gorodnichenko and M Weber (2022a), “Monetary policy communications and their effects on household inflation expectations", Journal of Political Economy, forthcoming.

Coibion, O, D Georgarakos, Y Gorodnichenko and M Weber (2022b), “Forward Guidance and Household Expectations”, manuscript.

D’Acunto, F, D Hoang and M Weber (2018), “Unconventional fiscal policy”, AEA Papers and Proceedings 108: 519–23.

D’Acunto, F, D Hoang, M Paloviita and M Weber (2019), “Cognitive abilities and inflation expectations”, AEA Papers and Proceedings 109: 562–66.

D’Acunto, F, A Fuster and M Weber (2021), “Diverse policy committees can reach underrepresented groups”, manuscript.

D’Acunto, F, D Hoang, M Paloviita and M Weber (2021), “IQ, expectations, and choice”, Review of Economic Studies, forthcoming.

D’Acunto, F, U Malmendier and M Weber (2021a), “Gender roles produce divergent economic expectations”, Proceedings of the National Academy of Sciences 118(21).

D’Acunto, F, U Malmendier, J Ospina and M Weber (2021b), “Exposure to grocery prices and inflation expectations”, Journal of Political Economy 129(5): 1615–1639.

D‘Acunto, F and M Weber (2022), “Memory and beliefs: Evidence from the field”, Working paper.

D’Acunto, F, U Malmendier and M Weber (2022), “What Do the Data Tell Us About Inflation Expectations?”, in R Bachmann, G Topa and W van der Klaauw (eds.), Handbook of Economic Expectations.

D’Acunto, F, D Hoang and M Weber (2022a), “Managing households’ expectations with unconventional policies”, Review of Financial Studies 35(4): 1597-1642.

D’Acunto, F, D Hoang, M Paloviita and M Weber (2022b), “Human Frictions to the Transmission of Economic Policies”, Manuscript.

D’Acunto, F, D Hoang, M Paloviita and M Weber (2022c), “Effective policy communication: Targets versus instruments”, Manuscript.

Das, S, C Kuhnen and S Nagel (2020), “Socioeconomic Status and Macroeconomic Expectations”, Review of Financial Studies 33(1): 395-432.

Fermand, E, C Kuhnen, G Li and I Ben-David (2018), “Expectations Uncertainty and Household Economic Behavior”, NBER Working Paper N. 25336. 

Lucas, R E (1975), “An equilibrium model of the business cycle”, Journal of Political Economy 83(6): 1113–1144.

Malmendier, U and S Nagel (2016), “Learning from inflation experiences”, The Quarterly Journal of Economics 131(1): 53–87.

Malmendier, U and A Steiny (2021), “Rent or buy? The role of lifetime experiences of macroeconomic shocks within and across countries”, Manuscript.

Roth, C and J Wohlfart (2020), “How do expectations about the macroeconomy affect personal expectations and behavior?”, Review of Economics and Statistics 102(4): 731-748.

Weber, M, Y Gorodnichenko and O Coibion (2022), “The expected, perceived, and realized inflation of us households before and during the covid19 pandemic”, IMF Economic Review, forthcoming.

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Topics:  Macroeconomic policy Monetary policy

Tags:  inflation, inflation expectations, interest rates, monetary policy, expectations formation, rational expectations

Assistant Professor of Finance at the Carroll School of Management, Boston College

Edward J. and Mollie Arnold Professor of Finance, Haas School of Business and Professor of Economics, University of California, Berkeley

Associate Professor of Finance, University of Chicago Booth School of Business

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