What Does Consumption Tell Us About Inflation Expectations And Real Interest Rates

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.

Controlling inflation is among the most important objectives of economic policy. By maintaining price stability, policy makers are able to reduce uncertainty, improve price-monitoring mechanisms, and facilitate more efficient planning and allocation of resources, thereby raising productivity. This volume focuses on understanding the causes of the Great Inflation of the 1970s and ’80s, which saw rising inflation in many nations, and which propelled interest rates across the developing world into the double digits. In the decades since, the immediate cause of the period’s rise in inflation has been the subject of considerable debate. Among the areas of contention are the role of monetary policy in driving inflation and the implications this had both for policy design and for evaluating the performance of those who set the policy. Here, contributors map monetary policy from the 1960s to the present, shedding light on the ways in which the lessons of the Great Inflation were absorbed and applied to today’s global and increasingly complex economic environment.

While there is ample evidence that high inflation is harmful, little is known about how best to reduce inflation or how far it should be reduced. In this volume, sixteen distinguished economists analyze the appropriateness of low inflation as a goal for monetary policy and discuss possible strategies for reducing inflation. Section I discusses the consequences of inflation. These papers analyze inflation's impact on the tax system, labor market flexibility, equilibrium unemployment, and the public's sense of well-being. Section II considers the obstacles facing central bankers in achieving low inflation. These papers study the precision of estimates of equilibrium unemployment, the sources of the high inflation of the 1970s, and the use of non-traditional indicators in policy formation. The papers in section III consider how institutions can be designed to promote successful monetary policy, and the importance of institutions to the performance of policy in the United States, Germany, and other countries. This timely volume should be read by anyone who studies or conducts monetary policy.

Standard theoretical models predict that higher inflation expectations generate greater current consumer spending at the zero lower bound of interest rates. However, recent empirical studies using U.S. micro data find negative results for this relationship. We use micro data for Japan, which has experienced low interest rates for a prolonged period, to estimate ordered probit models with a variety of controls. We find robust evidence supporting the prediction of standard models: survey respondents with higher expected inflation tend to indicate that their household has increased real spending compared with 1 year ago but will decrease it in the future. This relationship appears to be stronger for asset holders and older people.

This paper exploits a very large multi-country survey of consumers to investigate empirically the relationship between inflation expectations and consumer spending. We document that for the Euro Area and almost all of its constituent countries this relationship is generally positive: a higher expected change in inflation is associated with an increase in the probability that a given consumer will make major purchases. Moreover, in line with the predictions of macroeconomic theory, the impact is stronger when the lower bound on nominal interest rates is binding. Also, using the estimated spending probabilities from our micro-level analysis, we indirectly estimate the impact of a gradual increase in inflation expectations on aggregate private consumption. We find the effects to be economically relevant, especially when the lower bound is binding.

"The notion that expectations play a key role in economic decision making is a very old one. Over the past 100 years, major advances in the application of this insight in the formulation of economic models have been made in various subfields of economics. The concept of extrapolation, the idea that past observations of a series are the basis for making projections into the future, was present from the start of the modeling of dynamic economic processes"--

Using a new consumer survey dataset, we document a new dimension of heterogeneity in inflation expectations that has implications for consumption and saving decisions as well as monetary policy transmission. We show that German households with the same inflation expectations differently assess whether the level of expected inflation and of nominal interest rates is appropriate or too high/too low. The 'hidden heterogeneity' in expectations stemming from these opinions is related to demographic characteristics and affects current and planned spending in addition to the Euler equation effect of the perceived real interest rate. Furthermore, these differences in opinions affect German households differently depending on whether they are renters or homeowners.