How households’ inflation expectations matter
The monetary policy response to the recent Covid-19 crisis put many economies back to their lower bound in terms of the nominal interest rate. According to textbook macroeconomic models, managing inflation expectations is particularly important in this type of situation. Indeed, when the nominal interest rate is fixed, changes in expected inflation have a direct impact on the perceived real interest rate. This, in turn, affects households’ willingness to consume today, rather than to save and consume tomorrow. Policymakers, and in particular central banks, should avoid deflationary spirals that would further destabilise the economy. Further, forward guidance on interest rates that promises future inflation can stimulate aggregate demand via a lower real interest rate (Krugman 1998, Eggertsson and Woodford 2003, Werning 2012).
However, how the inflation expectation channel operates in practice remains unclear when looking at expectation data (Coibion et al. 2020). In particular, households seem to be poorly informed about current and future inflation as they disagree strongly about it, with a significant fraction of respondents having expectations that are far beyond the range of inflation realisations observed over the past years (Mankiw et al. 2003). Moreover, there is mixed evidence on the way households consume as a function of their inflation expectations, from being insignificant (or even negative) rather than positive (Bachmann et al. 2015). This begs the question of whether households’ inflation expectations really matter for their decisions, and for the transmission of economic shocks and stabilisation policies.
In a recent paper (Andrade et al. 2020), we provide new evidence that what matters in households’ inflation expectations for their individual consumption decisions is the broad inflation regime that households expect, rather than the precise inflation rate. This evidence has important implications for the inflation expectation channel of monetary policy.
Fluctuations of aggregate inflation expectations are mainly driven by their extensive margin
We use individual data from a rich survey of French households covering approximately 2,000 individuals every month since January 2004. This survey provides detailed qualitative and quantitative information on both perceived and expected inflation that we can connect to household’s durable consumption choices.
We first document that inflation expectations are quite heterogeneous. If 30% of households expect inflation to be between 1% and 3%, about 15% of households expect inflation to be equal or higher than 10% (while actual inflation in France fluctuated between -1% and 4% throughout 2004-2018). At the same time, a large share of households (more than 30% on average) simply answer that prices will “stay about the same” over the next year.
Besides, fluctuations in this share of households expecting prices to stay about the same (the extensive margin) contributes substantially to time-fluctuations in the average inflation expectation. In contrast, changes in the average expectation of households reporting positive inflation (the intensive margin) contribute much less (Figure 1).
Figure 1 Aggregate inflation expectations decomposition: extensive vs intensive margins
Overall, nearly 75% of the adjustment over time in the average inflation expectation comes from fluctuations in this share of households expecting prices to stay about the same (the extensive margin). Changes in the average expectation of households reporting positive inflation (the intensive margin) contributed the remaining 25%.
Variations in the extensive margin are not pure noise. The fluctuations of the share of households expecting stable prices are much more closely correlated with realised inflation (Figure 2a) than the non-zero average inflation expectation (Figure 2b). In particular, fewer households expect prices to stay about the same when realised inflation is higher.
Interestingly, the relation is quite non-linear. The proportion of households answering that prices ‘stay about the same’ decreases quickly when the actual inflation rate goes from 0% to 2%. For higher levels of inflation, the curve is flatter. By contrast, the average non-zero inflation expectation is rather flat for inflation between 0% and 2%, whereas it increases quite sharply in the case where inflation is above 2%.
Figure 2 Correlation of inflation expectation with realized inflation: Extensive vs intensive margins
a) Share of households expecting stable prices
b) Non-zero average inflation expectations
Consumption decisions mostly depend on the extensive margin
How do households relate their inflation expectations to their consumption decisions? To address this question, we test the connection using our survey data, linking a given household and its inflation expectation with its decision (or intention) to consume durable goods in the present period.
Our key result is that durable consumption increases mainly along the extensive margin. Figure 3 reports the marginal effect of inflation expectations on the likelihood to consume durables. Households expecting positive (but below 10%) inflation over the next year have a higher probability to buy new durable goods in the current year than households expecting that prices will remain stable over the same period. In contrast, there is no statistically significant difference in the likelihood to buy durables for any brackets of positive inflation expectations up to 10%. Finally, for households with an expected inflation rate of 10%, the effect on consumption decisions is the same as for those who expect stable prices.
Figure 3 Marginal effect of inflation expectations on the likelihood to consume durables
Overall, these findings suggest that what matters in inflation expectations is the broad inflation regime that households expect rather than the precise inflation rate.
In addition, we investigate how this positive correlation differs depending on households’ characteristics. First, we find a stronger effect of inflation expectations for richer, older, and more educated households. We also find that there is no statistically significant difference between men and women. In contrast, for younger, lower-educated, and poorer households (the bottom quartile of the income distribution), inflation expectations do not necessarily have a statistically significant effect on durable consumption.
Finally, within the study we also provide evidence of similar broad inflation regimes in a similar survey conducted in Germany and in the US Michigan survey.
Implications for the expectation channel of monetary policy
Our findings have important implications for the use of inflation expectations for policy guidance.
A first implication is related to the use of surveys of inflation expectations by policymakers. The large dispersion typically observed in the distribution of households’ inflation expectations does not mean that they are uninformative: an important and informative component of this dispersion is the share of households expecting prices to remain stable. While central banks devote more and more effort to monitor households’ inflation expectations, they should pay particular attention to this extensive margin of inflation expectations rather than to the usual intensive margin. The extensive margin would be useful for gauging the risk of a de-anchoring of inflation expectations. According to our results, a significant and persistent increase in the share of households expecting that prices will remain stable will put a drag on private consumption. However, this type of de-anchoring could coincide with a relatively stable average of individual inflation expectations (and so would remain unnoticed if one only pays attention to this average expectation as is often done).
A second implication is that the ability to manage current aggregate demand by manipulating inflation expectations is more limited than in models where consumption reacts continuously to changes in inflation expectations. According to our results, these policies need to convince households to switch from a “stable prices” regime to a “positive inflation” regime in order to boost aggregate demand. This finding could help to rationalise the recent findings of D’Acunto et al. (2020), who show that temporary VAT increases have a much clearer expansionary impact on households’ consumption than forward guidance on future policy rates. Households pay more attention to (and understand better) the former type of policy tool. This means that it is probably more effective at changing the inflation regime that people expect, compared to the latter.
Inflation expectations in the Covid-19 crisis
During the Covid-19 pandemic, households’ inflation expectations increased on average. Figure 4a below shows that the balance of opinions in the French survey of households’ inflation expectations was much higher than usual. More individuals expected relatively high inflation in April-May 2020 than in ‘normal’ times (Gautier et al. 2020). Does this mean that inflation expectations helped sustain private consumption by lowering households’ perceived real interest rate? According to our results, one should look at the share of households expecting positive inflation to answer that question. Figure 4b illustrates that, during the Covid-19 crisis, this share remained relatively anchored at levels close to 75%. So, one should not expect any positive impact of the increase in the average of individual inflation on private consumption. At the same time, the fact that the share of households expecting positive inflation remained roughly stable helped stabilise the economy and limit the risks of a deflationary spiral.
Figure 4 Inflation expectations and inflation during the Covid-19 pandemic
a) Balance of opinion
b) % of HH expecting price increase
Authors’ note: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.
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