Biases In Survey Inflation Expectations

This paper documents five facts about inflation expectations in the euro area. First, individual inflation forecasts overreact to individual news. Second, the cross-section average of individual forecasts of inflation underreact to shocks initially, but overreacts in the medium term. Third, disagreement about future inflation increases in response to news when the current inflation is high, and declines when inflation is low, consistent with a zero lower bound of expectations. Fourth, overreaction of individual inflation forecasts to news increased after the global financial crisis (GFC). Fifth, the reaction of average expectations (and of actual inflation) to shocks became more muted post-GFC in the euro area, but not in the U.S.

Disagreement in inflation expectations observed from survey data varies systematically over time in a way that reflects the level and variance of current inflation. This paper offers a simple explanation for these facts based on asymmetries in the forecasters' costs of over- and under-predicting inflation. Our model implies (i) biased forecasts; (ii) positive serial correlation in forecast errors; (iii) a cross-sectional dispersion that rises with the level and the variance of the inflation rate; and (iv) predictability of forecast errors at different horizons by means of the spread between the short- and long-term variance of inflation. We find empirically that these patterns are present in inflation forecasts from the Survey of Professional Forecasters. A constant bias component, not explained by asymmetric loss and rational expectations, is required to explain the shift in the sign of the bias observed for a substantial portion of forecasters around 1982.

Inflation is regarded by the many as a menace that damages business and can only make life worse for households. Keeping it low depends critically on ensuring that firms and workers expect it to be low. So expectations of inflation are a key influence on national economic welfare. This collection pulls together a galaxy of world experts (including Roy Batchelor, Richard Curtin and Staffan Linden) on inflation expectations to debate different aspects of the issues involved. The main focus of the volume is on likely inflation developments. A number of factors have led practitioners and academic observers of monetary policy to place increasing emphasis recently on inflation expectations. One is the spread of inflation targeting, invented in New Zealand over 15 years ago, but now encompassing many important economies including Brazil, Canada, Israel and Great Britain. Even more significantly, the European Central Bank, the Bank of Japan and the United States Federal Bank are the leading members of another group of monetary institutions all considering or implementing moves in the same direction. A second is the large reduction in actual inflation that has been observed in most countries over the past decade or so. These considerations underscore the critical – and largely underrecognized - importance of inflation expectations. They emphasize the importance of the issues, and the great need for a volume that offers a clear, systematic treatment of them. This book, under the steely editorship of Peter Sinclair, should prove very important for policy makers and monetary economists alike.

We examine partisan bias in inflation expectations. Our dataset includes inflation expectations of the New York Fed's Survey of Consumer Expectations over the period June 2013 to June 2018. The results show that inflation expectations were 0.46 percentage points higher in Republican-dominated than in Democratic-dominated US states when Barack Obama was US president. Compared to inflation expectations in Democratic-dominated states, inflation expectations in Republican-dominated states declined by 0.73 percentage points when Donald Trump became president. We employ the Blinder-Oaxaca decomposition method to disentangle the extent to which political ideology and other individual characteristics predict inflation expectations: around 25% of the total difference between inflation expectations in Democratic-dominated versus Republican-dominated states is based on how partisans respond to changes in the White House’s occupant (partisan bias). The results also corroborate the belief that voters' misperceptions of economic conditions decline when the president belongs to the party that voters support.

Post-COVID, supply shock-induced spike in inflation in India has spawned renewed research interest in assessing the extent to which inflation expectations are anchored to the inflation target, given its importance to securing price stability in the medium run. This article constructs a bias-adjusted household inflation expectations series to show that such a measure contains useful forward-looking information for predicting headline inflation. It also presents an inflation expectation anchoring (IEA) index to highlight the significance of the flexible inflation targeting (FIT) framework to firmer anchoring of expectations and the role of repeated supply shocks in posing the risk of de-anchoring expectations.

This paper argues that individuals may rationally weight price increases for food and energy products differently from their expenditure shares when forming expectations about price inflation. We develop a simple dynamic model of the economy with gradual price adjustment in the core sector and flexible prices in the food and energy sectors. Serial correlation of supply shocks to food and energy allows individuals to gain an understanding about future shocks, possibly making it optimal for individuals to place more weight on the movement of prices in these sectors. We use survey data on expected inflation to show that the weights implied by the model differ from the expenditure shares of food and energy prices in the CPI for the United States. We find food price inflation is weighted more heavily and energy price inflation is weighted less heavily. But importantly, we cannot reject the hypothesis that these weights reflect rational behavior in forming expectations about inflation.