The importance of inflation expectations to central bank policy is well-understood.
Equally well-known is that there are different, sometimes conflicting measures of these expectations. Surveys of households will show different expectations than surveys of professional economists, and markets-derived inflation expectations (from inflation-indexed debt and the like) will show different results than these survey-based measures. Such subtleties as how a question is framed can change the result.
Central banks know all of these things and (say they) take them into account.
But how people go about forming expectations is still somewhat mysterious. To what extent do various macroeconomic variables matter? Are long-term expectations affected by short-term fluctuations? Is there a large status quo bias — that is, are expectations correlated with actual recent inflation?
Wading into the debate on Tuesday is a new study from the Bank of International Settlements, which attempts to shed a bit of light on the matter. But its conclusions turn out to be as interesting for what they say about the efficacy of ECB policymaking as about the psychology of where expectations come from.
The researchers started by separating their test subjects into three groups — Dutch central bank staffers, academics, and students — before conducting a weekly survey of short-, medium-, and long-term euro area inflation expectations over the course of more than a year.
A bit more on the methodology:
The data source for our analysis of inflation expectations is a new survey, which we carried out over the period July 2009 – July 2010. The survey has three novel features compared to existing surveys of inflation expectations. First, it has a considerably higher frequency than other surveys, especially those for long-term inflation expectations. This allows us to study more carefully some aspects of expectation formation, such as the frequency with which expectations at different horizons are revised. Second, participants in our survey are provided with common information sets. We can exploit this characteristic to provide new evidence on the role of information asymmetries in explaining the observed heterogeneity of expectations and to test for the role of focal points. Third, we introduce a pecuniary incentive for survey participants to respond as accurately as possible.
And some of the noteworthy conclusions (emphasis ours):
We find that the mean and median rose for short- and medium-term inflation expectations – suggesting that participants expected the economic climate in the euro area to gradually normalize – but remained stable for long-term expectations.
We find that the disagreement around these means and mediums was smallest at the longterm horizon. This is consistent with our finding that long-term expectations have remained well anchored, as suggested by stable first moments close to the ECB’s definition of price stability and the fact that long-term expectations have not been sensitive to news about HICP inflation or changes in short-term or medium-term inflation expectations. We also find that the ECB’s definition of price stability is the only focal point for long-term expectations.
Sovereign debt concerns triggered by the Greek fiscal crisis had some influence on short- and medium-term inflation expectations, and, albeit to a very small degree, long-term expectations. By contrast, we do not find evidence that long-term expectations reacted to developments of the euro area wide fiscal burden.
The weekly frequency of our survey is important, since participants changed their expectations quite frequently. Each week, more than a third of the participants updated their one-year inflation expectations, while about a quarter of survey respondents changed their ten-year expectations. The longer the horizon, the less frequent but larger the revisions are. …
Inflation expectations appear fairly homogenous across groups of agents at the shorter horizon but less so at the medium- and long-term horizons. At the one-year horizon, expectations appear homogenous to the extent that the mean and median of expectations are similar across groups. Moreover, the most recent actual inflation figure is an important driver of short-term inflation expectations for all three groups.
Well, at least people take the ECB seriously about something.
Related links:
“Transitory” in two graphs – FT Alphaville
Deflated inflation expectations – FT Alphaville
The qualifier in Yellen’s speech – FT Alphaville
Two more views on inflation expectations – FT Alphaville