RDP 2016-02: Disagreement about Inflation Expectations 2. Why Does Disagreement Arise?

Before investigating the behaviour of disagreement in inflation expectations, we briefly summarise prominent models of expectations formation. This helps us understand how disagreement about expectations can arise, and generates predictions about its behaviour. Furthermore, because theoretical models make different predictions about the behaviour of forecast disagreement, we can use the observed behaviour of forecast disagreement to draw implications about the expectations formation process. We focus on four prominent models of expectations formation.

Full information rational expectations

The full information rational expectations (FIRE) model assumes that agents efficiently process all available information; forecasts are identical across agents, and thus there is no disagreement about expectations. Because the FIRE model incorporates no frictions, it is a stark description of reality. But the FIRE assumption underpins a wide range of macroeconomic models, and so provides a benchmark from which to gauge the predictions of richer models.

Sticky information

The sticky-information model assumes that information acquisition and processing requires costly effort (Reis 2006). Accordingly, agents only periodically update their forecasts. The sticky-information model retains the assumption of rational expectations; that is, agents are assumed to form forecasts consistent with rational expectations when updating their beliefs. Disagreement rises in response to a macroeconomic news surprise because at any point in time only a fraction of agents update their forecasts to incorporate the news (the models of Mankiw and Reis (2002) and Reis (2006) assume updating occurs at random intervals). Disagreement will tend to decay over time as the fraction of agents incorporating the news into their expectations increases, but providing the frequency of macroeconomic news surprises is high relative to the speed at which agents update their expectations (as is the case in most parameterisations of the model), there will be disagreement among agents at all times.

At a conceptual level, the sticky-information model provides a plausible description of consumer behaviour. Interpreted literally, the assumption that agents only periodically update their expectations is inconsistent with the behaviour of professional forecasters but, interpreting the information friction more broadly to reflect periodic or infrequent changes in model parameters and structural breaks, the sticky-information framework may nonetheless apply to professional forecasters.

Noisy information

Noisy-information models assume that agents filter noisy data to infer the true state of the economy (Lucas 1972; Sims 2003; Woodford 2003). In contrast to the sticky-information model, agents are assumed to update their forecasts continuously. A striking prediction of the baseline noisy-information model is that disagreement will not respond to macroeconomic news (Coibion and Gorodnichenko 2012). Although individual agents face signals with different idiosyncratic errors at any point in time, the precision of signals in the baseline noisy-information model is assumed to be uncorrelated with macroeconomic news shocks and the same across agents, in which case disagreement is constant over the business cycle. Coibion and Gorodnichenko (2012) show that the absence of a response of disagreement to macroeconomic news extends to richer noisy-information models featuring strategic interaction among forecasters (e.g. forecasters may not want to deviate too far from the average). But they show that the noisy-information model can generate an increase in disagreement in response to macroeconomic news if the precision of signals differs across agents.

Disagreement about means

Disagreement among agents may arise because of differences in beliefs about long-run means (Patton and Timmerman 2010). For example, agents may have different priors on the inflation credibility of a central bank, and so form different views about the expected level of inflation at short and long horizons. Because this type of disagreement does not reflect different information sets available to forecasters, disagreement does not respond to macroeconomic news surprises (Coibion and Gorodnichenko 2012).

This discussion is summarised in Table 1 below.