The Role of Inflation Expectations in Monetary Policy
IMF News, May 15, 2023
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- Published: May 15, 2023
Overview
- Topic: Which inflation expectations matter for policymaking (forecasters, markets, households) and across horizons (near-term vs longer-term).
- Context: Actual inflation is "far off target in many countries around the world," increasing focus on whether inflation expectations remain anchored.
- Remarks: IBF / Deutsche Bundesbank Symposium — Remarks by Tobias Adrian, IMF Financial Counsellor and Director of the Monetary and Capital Markets Department, May 15, 2023.
Historical role of inflation expectations
- Early Phillips curve frameworks omitted expectations; Samuelson and Solow (1960) introduced a modified price-inflation Phillips curve implying a trade-off policymakers could exploit.
- Empirical breakdown in the mid-1960s and The Great Inflation (1970s–early 1980s) led to recognition of supply shocks and stagflation (Gordon 1975; Blinder, 2022).
- Phelps and Friedman emphasized the role of inflation expectations: deviations from the natural rate of unemployment shift the short-run Phillips curve; unemployment below the natural rate increases inflation expectations, shifting the curve up.
- By the Volcker era, long-run inflation expectations became a central focus; long-term bond yields (assumed minus risk premia) were used as imperfect proxies.
- Observed long-term nominal yields rose from "roughly 4 percent in the early-1960s to nearly 20 percent by the late-1970s," interpreted as de-anchoring and a symptom of low central bank credibility.
- Volcker disinflation experience: observed inflation fell more quickly than long-run expectations (proxied by long-term bond yields), and the federal funds rate stayed higher for much longer; credibility took time to be regained.
Which measures of expectations matter
- Central banks remain attentive to long-run market- and survey-based inflation expectations as signals of policy credibility and channels for monetary transmission.
- Open questions: Are well-anchored long-term market expectations sufficient to assume inflation will return to target, or do other dimensions matter?
- Other important dimensions:
- Horizon: Shorter horizons matter most for actual inflation in theory and practice.
- Agent: Households and firms have distinct expectation formation and transmission channels.
- Evidence on firms and households:
- Firms' expectations affect investment, hiring, and price-setting (Gorodnichenko & Coibion, 2018).
- Households' expectations affect consumption, saving, home-ownership, financing decisions, wage negotiations, and labor supply (Andrade et al., 2020; Duca-Radu et al., 2021).
- Interpersonal disagreement and heterogeneity of beliefs are informative (Andrade et al., 2019).
Household expectations — key findings
- Historically viewed as volatile and dispersed, household inflation expectations improve empirical performance of the New Keynesian Phillips Curve when used in surveys.
- Dispersion and shifts in the distribution of household expectations contain information not captured by mean/median measures.
- IMF working paper (to be released soon) on household survey micro-data for Canada, Germany, the US, and the UK: shifts in the distribution of one-year-ahead household expectations predict one-year-ahead inflation and provide additional information beyond market and professional forecasts.
- Theoretical and empirical notes:
- Use of survey expectations improves the New Keynesian Phillips Curve but conflicts with the model's rational expectations microfoundations.
- Meeks and Monti (forthcoming) derive a Phillips curve with non-rational expectations where heterogeneity (distribution of beliefs) matters for current inflation; upside-skewed and dispersed expectations can reinforce adverse effects of higher average expected inflation.
- Household expectations and demand:
- Higher inflation expectations increase consumption; positive inflation expectations increase the marginal propensity to consume for durables.
- Households expecting stable prices have a lower propensity to buy durables than those expecting positive inflation.
- Personal experience of high inflation raises subsequent inflation expectations and increases preference for buying versus renting a house (Malmendier and Wellsjo, 2020).
- Inflation expectations influence mortgage financing choices (fixed vs floating) (Malmendier and Nagel, 2016; Botsch and Malmendier, 2021).
- Labor market effects:
- Short-term household inflation expectations are relevant for the wage Phillips Curve.
- Effects on labor supply and wage setting may be regime-dependent (Rudd, 2021): low-stable inflation regimes see little effect; persistent high-inflation regimes can make expectations central to wage negotiations and labor supply decisions.
- Formation of household expectations:
- Central bank communication generally has limited influence on household expectations; households respond mostly to information related to the inflation target (Coibion et al., 2022).
- Personal experiences matter strongly: experiencing high aggregate inflation has long-lasting effects (Malmendier and Nagel, 2016); personal exposure to price changes matters more for frequently purchased items and for price increases versus price drops (D’Acunto et al., 2021a, 2021b).
- Personal experiences affect professionals as well (example: Henry Wallich’s dissenting votes related to past hyperinflation experience).
Current conjuncture and measurement signals
- Long-run inflation expectations currently "seem to have remained fairly well anchored."
- Market-based inflation expectations remain elevated, evidenced by current one-year inflation swap rates.
- Short-term household expectations also remain high, though most-recent data show short-term inflation expectations for the US and the Euro area are coming down.
- Declines in household inflation expectations lag those of market participants, raising the question of whose expectations matter for implied real interest rates:
- With high household inflation expectations, implied real rates for households might be lower than those estimated for markets.
- Consequence: an effectively easier monetary policy stance for households than suggested by market-based measures, and a more muted effect on aggregate demand.
Implications for monetary policy
- Policymakers should attend to both long-run and short-term expectations; both provide important signals of policy credibility and affect transmission.
- Risks:
- Persistent high inflation increases the risk of expectations de-anchoring.
- Because household expectations respond more strongly to price increases than to price cuts, lowering expectations can take longer than raising them.
- People are relatively inattentive to inflation unless in a high-inflation regime; entering such a regime can make inflation and expectations much more persistent.
- Communication limits:
- Central bank communication may be ineffective at influencing firms' and households' expectations; people often get inflation information from television and newspapers rather than directly from the central bank.
- This strengthens the argument for swift and tight policy action to bring actual inflation down quickly, minimizing the duration of high inflation and its experiences.
- Importance of institutional frameworks:
- Inflation expectations are lower in countries with strong monetary policy frameworks.
- Strong frameworks rely on robust laws defining central bank independence and accountability, and on sound design, implementation, and communication practices.
Policy recommendations and risk-management stance
- Do not presume inflation will return to target solely because long-term market-based expectations appear anchored.
- Place more emphasis on short-term inflation expectations, especially household expectations, given their predictive power for near-term inflation and transmission through demand.
- Act swiftly and maintain a tight policy stance to:
- Reduce actual inflation quickly.
- Minimize public experience of high inflation (which shapes expectations).
- Prevent de-anchoring that would make disinflation more painful.
- Build and maintain strong monetary policy frameworks backed by robust laws and consistent practices to support lower inflation expectations.
Conclusion — summary points
- Inflation expectations are a critical input to monetary policy across agents (forecasters, markets, households) and horizons (near-term and long-term).
- Long-run expectations matter for credibility and transmission, but short-term household expectations are important additional predictors of inflation and matter for demand, wages, and financing decisions.
- The experience of high inflation can have lasting effects on expectations; thus, risk management favors continued tight policy and strong institutional frameworks.
Remarks by Tobias Adrian, IMF Financial Counsellor and Director of the Monetary and Capital Markets Department, May 15, 2023.