RDP 2016-02: Disagreement about Inflation Expectations 1. Introduction

Inflation expectations play a central role in modern monetary economics. Reflecting the importance of inflation expectations to monetary policymaking, there is a large literature studying their behaviour. Much of the literature has focused on understanding how expectations are formed and adjust: Are expectations rational? How do expectations adjust in response to changes in monetary policy regimes? However, there is comparatively little work studying the behaviour of disagreement about inflation expectations.^[1] In part, this reflects the absence of a role for different beliefs in most macroeconomic models.

Understanding the behaviour of disagreement is of interest to a central bank for a few reasons. First, the welfare costs of inflation are often thought to arise not from the level of inflation per se, but rather uncertainty about future inflation (Friedman 1977). An important justification for targeting a low level of inflation is that it is more likely to be associated with more predictable inflation (Ball (1992) provides a theoretical model linking the level of inflation to inflation uncertainty). More dispersed expectations are likely to be indicative of larger average absolute forecast errors, and so higher costs from inflation uncertainty.

Second, less disagreement might indicate better anchoring of expectations. In particular, disagreement might reflect different beliefs about trend inflation, possibly arising from different perceptions of the credibility of the central bank's inflation target. Previous research has found that inflation expectations tend to be less dispersed in economies that have inflation-targeting central banks, consistent with there being a link between disagreement and inflation credibility (Capistrán and Ramos-Francia 2010).

Third, the behaviour of disagreement can help discriminate between different models of expectations formation. In particular, dispersed expectations can result from costly, and therefore infrequent, processing of information among agents, or uncertainty about the structure of the economy. Models incorporating disagreement can explain some empirical regularities that representative agent models cannot. For example, models featuring disagreement can explain the delayed response of inflation and output to monetary policy shocks, whereas the benchmark New-Keynesian Phillips curve, which features no disagreement among agents, cannot (Mankiw and Reis 2002; Woodford 2003; Mackowiak and Wiederholt 2009). This makes it important to document the extent of disagreement and to understand its behaviour.

This paper examines key stylised facts about disagreement surrounding inflation expectations in Australia. In doing so, we employ several novel datasets. In particular, we use individual response data from five different surveys: two of market economists, one of union representatives, one of consumers, and a survey by The Age newspaper that is a mix of mostly professional forecasters from financial markets, unions and academia. For the consumer measure, we use a new method to identify the underlying distribution, separate from noise introduced by infeasible and clustered responses. We do not have survey data on expectations for managers involved in pricing decisions, but Kumar et al (2015) provide evidence from New Zealand that expectations of managers closely resemble those of consumers.

From an inflation forecasting perspective, the expectations of professional forecasters such as market economists might be most relevant, because professionals put significant resources into understanding the likely trajectory of inflation. But consumer and union measures may provide information on the expectations embedded in wage negotiations, and thereby influence the trend rate of inflation.

The empirical analysis addresses two key questions. First, we examine whether historical disagreement provides some clues as to how agents form their expectations. There are several prominent models of expectations formation that help us understand how disagreement in expectations can arise. Under the benchmark assumption used in most macroeconomic models – full information and rational expectations – there is no disagreement. However, disagreement can occur in models relaxing the assumption of full information. The sticky-information model proposed by Mankiw and Reis (2002) assumes only a fraction of agents are attentive each period and so form updated expectations; disagreement occurs because agents update their expectations at different points in time. Noisy-information models assume agents observe fundamentals with errors, so generate disagreement because individuals observe different signals. Disagreement may also arise because of persistent differences in beliefs about the mean level of inflation. We interpret the behaviour of disagreement in light of these models, making inference about how expectations are formed.

In all, the behaviour of disagreement over time does not fit neatly within any particular model, although we do find evidence consistent with information rigidities. The extent of disagreement appears to respond little to most macroeconomic news surprises, although we do find some evidence that disagreement rises in response to surprise changes in GDP growth, and when current inflation deviates from the middle of the Reserve Bank of Australia's (RBA) 2–3 per cent target. There have been several episodes since the introduction of inflation targeting in which disagreement has risen noticeably among all groups of agents.

Second, we consider disagreement as an indicator of the anchoring of inflation expectations in Australia, both across time and agents. Provided inflation expectations are close to the target level on average, a lower level of disagreement indicates more firmly anchored inflation expectations. We document an approximate halving in disagreement about inflation expectations among respondents to The Age's economic survey since the adoption of inflation targeting. We also find evidence of a decline in disagreement for both surveys of market economists, by about half relative to periods in the mid to late 1990s.

Consumers' inflation expectations generally appear much less anchored than those of professionals. The magnitude of disagreement among consumers is substantial – about five times that of professionals. A large majority of consumers expect inflation to lie outside of the RBA's target over time, with a sizeable fraction expecting inflation above 10 per cent. Unlike professionals, there is no evidence of a decline in disagreement since the introduction of inflation targeting. However, disagreement for consumer inflation expectations is estimated to co-move with the expected level of inflation, implying that disagreement among consumers may have declined since the 1980s when consumer inflation expectations were substantially higher; unfortunately unit record data before 1995 are unavailable to test this implication. Finally, there are persistent differences in inflation expectations according to individuals' demographic characteristics, which indicate different perceptions of long-run inflation.

Part of the disagreement in consumer expectations appears to be due to a large share of uninformed (or misinformed) responses. Consistent with this, a notable feature of consumer inflation expectations is their sensitivity to petrol prices, which provides evidence of non-rationality. This also provides evidence against the sticky-information model of expectations, which assumes that the frequency of updating is time- rather than price-dependent.

The survey question, which asks consumers about changes in the prices of the things they buy, is another contributor to disagreement about consumer inflation expectations. Because price changes differ across goods, individual inflation experience depends on differences in spending patterns across consumers. However, we find that differences in individual inflation experience can account for only a small fraction of the disagreement about consumer inflation expectations.

Footnote

For the United States, Mankiw, Reis and Wolfers (2004) is a notable exception. More recently, Andrade et al (2014) analyse the term structure of disagreement for inflation, GDP growth, and the federal funds rate. For Australia, Brischetto and de Brouwer (1999) document differences in mean consumer inflation expectations by demographic characteristics among respondents to the Melbourne Institute survey of households' inflation expectations. [1]