Inflation Expectations

Peter J. N. Sinclair, Peter J N Sinclair

• Publisher: Routledge
• Year: 2009
• eBook ISBN: 9781135179779
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

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.

1
Inflation expectations

An introduction

Peter Sinclair¹

On 10 July 2007, the Chairman of the Federal Reserve Board, Ben Bernanke, (Bernanke 2007), gave a major speech at the National Bureau of Economic Research, in Cambridge, Massachusetts. He chose to devote it to the topic of Inflation Expectations.

That choice may have been motivated by the fascinating debate on the role that inflation expectations had played in the Great Moderation—the remarkable decline in the average level and variability of inflation that the world’s leading economies have witnessed since the early 1990s. It may also have been prompted by a small but growing sense of alarm that, with recent rises in inflation, this phase might be drawing to a close. The issue of what tethers inflation expectations to a target, declared or implicit, is now uppermost in many central bankers’ and economists’ minds: that, and fears that, in the wake of the explosion of many primary commodity prices from 2004, they might start to get detached from it.

The Bernanke speech followed close upon an important conference in Warsaw, organized by the National Bank of Poland in 2006. That conference was devoted, too, to inflation expectations. This volume presents newly finalized versions of papers that were presented there. Why are inflation expectations so important?

Part of the answer runs like this. Beyond some pretty modest levels, both unemployment and inflation are invariably thought of as social ills. They are the classic two ingredients of “economic misery”. It is the monetary authorities’ task to try to minimize them—or more properly, in most approaches, the discounted future stream of the weighted sum of the squares of their deviations from optimal or equilibrium values. There is one thing that everyone agrees must increase at least one of these two sources of misery, and often both. That is the expected rate of inflation. Expectations of higher inflation shift up the short-term trade-off (the Phillips curve) between actual inflation on the one side, and unemployment (or some measure of lost output, which will accompany the unemployment: the difference between actual real GDP and its trend value, the output gap, should betray this) on the other. That must entail higher actual inflation at a given rate of unemployment (or higher unemployment at a given rate of inflation).

This is the unambiguously sinister side of inflation expectations. Sometimes a rise in them could appear more benign. All else equal, it should lead to higher consumption and investment spending, in response to the lower expected real interest rate. This will not occur, however, if the rise in expected inflation is more than offset by an accompanying (or staggered) jump in nominal (policy) interest rates. The Taylor Rule² will advise just that, since anything less can only cause instability. Assume that the central bank is believed to follow the precepts of the Taylor Rule.³ In this case, a rise in near-future inflation expectations will make agents anticipate higher real interest rates; they will then see that that should squeeze output and jobs later on; and the end result will be a fall in the current expectations of inflation at or a little beyond that horizon. When prices are expected to decline, on the other hand, the zero lower bound to nominal policy rates means that real aggregate demand will be boosted (depressed) by expectations of slower (faster) decline in the rate of inflation. Recent Japanese experiences have shown that this threat is no laughing matter.

With this one exception, then, we learn two things: first, that higher (lower) inflation expectations have the potential, typically, to create major economic damage (benefit); and second, that the size and character of those effects will depend critically on how agents think the central bank will react. At its best, a fully credible central bank, committed to fighting inflation as a first priority, should succeed in keeping inflation expectations steady, at least on average over time. Departures from any explicit or inferred target should then be brief—and small.

So inflation expectations are of enormous practical importance, a point stressed forcefully recently by Mishkin (2007). If expectations were fully rational, all they would do would be to reflect (presumably the latest) information and knowledge. They would simply be consistent with “the” model, whatever that might be.⁴ They would not really have any life of their own. And presumably we would observe them only indirectly. There would be an element of circularity: it would be rather like using consumption spending to infer the income expectations upon which they were assumed to be based.

True, inflation expectations can be inferred from an estimated model, under the assumption of rational expectations. But we have two other potential sources for them, both of them effectively independent of the model in which we formalize their influence upon the course of actual inflation and output. One is financial data, such as those on the prices and relative yields of both indexed and unindexed bonds. The second is surveys. This volume is devoted to the latter.

Why study surveys? One practical answer is provided by Ang et al. (2007). US evidence, they find, shows that inflation expectations culled from surveys actually turn out to be better predictors of subsequent actual inflation than either statistical macroeconomic models, or financial asset price data. A second argument turns on the fact that the size and character of macroeconomic models are disputed: model-based expectations require the investigator to preselect the model. Third, there is the point that financial market data may be contaminated by transaction costs, risk premia, tax treatment questions, and, above all, data paucity. In many countries, indexed bonds are comparatively recent, if they exist at all, and the range of maturities on which they are offered, if any, is invariably very limited. Of course one need not confine oneself to any one source: Fu (2007) shows that there are interesting lessons to be learnt from combining surveys and financial market data. Nonetheless, survey data are remarkably rich and extensive, and surely merit close attention. And, like Mount Everest, they exist.⁵

All sorts of questions arise, to which survey data can enable us to obtain some answers. For example, to what extent do survey-based inflation forecasts in fact qualify as rational? How big are the departures from rationality—trivial, appreciable, or really pronounced? How long do such departures, if any, tend to persist? Does actual inflation betray good links with, and/or strong influences from, prior expectations of inflation in the relevant period? Are economic experts better or worse at predicting inflation than sampled households? Are there any other differences between the two groups? Do survey expectations show evidence of learning? Are they adaptive, and if so to what, when, and how quickly? What can be learnt about lags, and the serial correlation patterns? Is there evidence, from the massive survey evidence accumulated in the United States, for example, that the answer to these questions has been changing over time? Does the evidence actually vary across countries? Does the United States differ from West European countries in such respects? Is Western Europe homogeneous or diverse? Do the transition countries of Central and Eastern Europe manifest similar or different behaviour in their inflation—inflation expectations relationships? And other narrower but intriguing questions: are some countries’ households better at predicting inflation than others’, for example?

Then there are prior questions. Typically, most survey questions have been qualitative or comparative; and some can be tantalizingly vague. For example: Do you think prices will increase in the coming year? Will the rate of inflation increase? Will prices stay roughly the same? The interrogators will attempt to collate the respondents’ varying answers, which will be distributed between various ranges or buckets. Moving from this coarse partitioning towards a continuous distribution is a journey fraught with hazard. Assuming a particular class of distribution will help, but is this not rather arbitrary? The goal will be to try to capture some quantitative estimate of the centre of the distribution of inflation expectations from the survey data. But which? The mean? Might not the median provide a safer measure of “average opinion”, particularly if tails are long, large, and, above all, asymmetric? And what about the standard deviation (or variance) to inform us of the degree of dispersion? Or some other measure, such as the 95 per cent confidence limits, or the range between the first and third quartiles? More generally, what are the pros and cons of different ways of converting answers to qualitative questions into quantitative form? And can we use evidence to tell us which method is best?

Furthermore, what is the statistical relationship between perceptions of inflation, and either expectations of future inflation or actual inflation outturns? Have perceptions and actual inflation converged? What are the lessons learnt from the adoption of euro notes and coins in 2002 in this regard?

If agents differ in their inflation expectations, that is itself prima facie evidence against rational expectations in its purest form. Heterogeneous answers to survey questions may point to irrationality, but they might also reflect differences in people’s spending patterns at a time when relative prices had diverged, or were thought likely to. But heterogeneity of expectations would have to be accepted as a fact. Could it be reconciled, though, with a less restrictive form of rational expectations, which made some allowance for the costs of gathering, updating and processing information? Is information actually “sticky” in the way we assume many goods and factor prices are? And what might it imply for monetary policy if expectations were heterogeneous—would it reinforce or modify the case for fighting inflation vigorously?

It is in the labour market that inflation expectations probably play the biggest role. Money wage rates are renegotiated at discrete intervals. Employers’ and employees’ expectations of inflation over the upcoming interval will be key in determining the size of nominal pay rises agreed upon. Can we therefore use labour markets as a test bed for our different methods of quantifying inflation expectations from survey data? And if we do, what do we find?

Some of these questions have been explored before. There are valuable survey papers, for example, by Thomas (1999) on US inflation expectations survey evidence. There are interesting discussions, for instance by Mankiw et al., (2003) on sticky information and the dispersal of inflation expectations. We have a really magisterial analytical survey on the general issue of measuring expectations by Manski (2004). And the distinguished contributors to this volume have themselves, between them, a remarkable corpus of publications touching on several of these questions. But, many of the questions posed here have not been addressed before; and even the more familiar questions attract somewhat different or more nuanced answers, particularly in the context of a broad group of papers studying several different countries.

Let me now attempt a brief sketch of the chapters that follow this introduction. I shall not spoil the reader’s appetite by attempting a summary of them; all chapters are accompanied by carefully written introductions and conclusions that perform this task well. Rather, I shall describe some of the key issues they address.

The first chapter is by Roy Batchelor, whose pioneering contributions to the study of expectations surveys stretch back over two decades. Here, Batchelor develops and compares different methods of translating ...

Table of contents

• Routledge international studies in money and banking
• Contents
• Illustrations
• Contributors
• 1 Inflation expectations
• 2 How robust are quantitied survey data?
• 3 Inflation expectations and empirical tests
• 4 Heterogeneous expectations, adaptive learning, and forwardlooking monetary policy
• 5 Consumer inflation expectations
• 6 Further evidence on the properties of consumers’ inflation expectations in the euro area
• 7 Household versus expert forecasts of inflation
• 8 The role of expectations in the inflation process in the euro area
• 9 The European consumer and monetary policy
• 10 Testing near-rationality using survey data
• 11 400,000 observations on inflation perceptions and expectations in the EU
• 12 Finding the optimal method of quantifying inflation expectations on the basis of qualitative survey data
• Index