What drives long-run inflation expectations?

Stefano Eusepi, Emanuel Moench, Bruce Preston and Carlos Carvalho
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Stefano Eusepi: Federal Reserve Bank of New York

No 1228, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: According to both central bankers and economic theory, anchored inflation expectations are key to successful monetary policymaking. Yet, we know very little about the drivers of inflation expectations -- especially about the long run. We explore a simple model of expectations formation and inflation determination in which the sensitivity of long-run inflation expectations to short-run inflation surprises is state-dependent. Price-setting agents act as econometricians trying to learn about average long-run inflation. They set sticky prices according to their views about future inflation, which hence feed into actual inflation. As in Marcet and Nicolini (2003), agents' estimates of long-run inflation move slowly in normal times, as they keep adding observations to the sample they consider. However, after being surprised repeatedly/largely enough, agents discard old observations and put more weight on recent developments. As a result, long-run inflation expectations become more sensitive to short-run news. We estimate the model using only short-run inflation forecasts from surveys, and find that it produces long-run forecasts that track survey measures quite closely. The estimated model has several uses: 1) It can tell a story of how inflation expectations got unhinged in the 1970s; it can also be used to construct a counterfactual history of inflation under anchored long-run expectations. 2) At any given point in time, it can be used to compute the probability of inflation or deflation scares. 3) If embedded into an environment with explicit monetary policy, it can also be used to study the role of policy in shaping the expectations formation mechanism.

Date: 2015
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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