RDP 2024-07: How Do Households Form Inflation and Wage Expectations? 2 Related Literature

Over the past decade or so the empirical literature on the nature and drivers of inflation expectations has grown significantly. As summarised in Weber, D'Acunto et al (2022), this literature has evolved with the growing availability of survey data (particularly respondent-level data), as well as the introduction of survey experiments. These have contributed to a large improvement in our understanding of consumers' inflation expectations, which tend to be upwardly biased, highly dispersed and uncertain, and disproportionately driven by certain salient prices.

Our paper contributes to several strands of this literature. The first is the portion exploring the relationship between sentiment and inflation expectations. Kamdar (2019), Candia et al (2020), and Andre et al (2022) document across several advanced economies a negative relationship between consumers' sentiment about the economy and their expectations for inflation. They put forward different explanations for this finding, including that households tend to make good–bad heuristic associations (i.e. inflation is bad and so is associated with bad things), that households focus more on certain channels of shock propagation, or that people focus on different sources of inflation shocks. Haidari and Nolan (2022) document a similar relationship for Australia.

Most closely related to our work, Jain et al (2022) use household-level data to look at the relationship between household-level expectations for wages and prices growth and economic conditions. As in previous work, they find a negative relationship between conditions and inflation expectations, but a positive relationship between wages and conditions. This is also evident for spending intentions.

Also related is the literature exploring the links between inflation and wage expectations. Using the same framework mentioned above, Jain et al (2022) find a relatively weak association between inflation and wage expectations. Several papers have also found similar results using experimental approaches, providing stronger causal evidence. For example, Hajdini et al (2023), using an experimental design with US consumers, find pass-through of expected inflation to income growth of only around 20 per cent, with pass-through tending to be higher for higher income individuals. As such they expect higher inflation to be associated with lower real income. Savingnac et al (2021) find similar results for firms in France. Several of these papers argue that such limited direct feedback from households' inflation expectations and perceptions to their wage expectations could limit the scope for ‘price–wage’ spirals, and more generally for amplification of supply shocks through such a mechanism.

This literature also explores the policy implications of these findings. In particular, Coibion et al (2023) provide causal evidence that providing information about higher inflation to Dutch households led them to undertake less durable spending rather than more (as would be predicted by standard theories), which they argue likely reflects lower expected real income. They argue that this highlights the potential for central bank communications aimed at moving inflation expectations to have unintended effects, and as such nuanced communication and education that draws out broader economic implications and channels may be helpful. And Binetti et al (forthcoming) find that consumers tend to believe there is little to no trade-offs between inflation and economic conditions, and that therefore there is a resistance to using monetary policy to bring down inflation by weakening aggregate demand. This naturally makes communication of a central bank's strategy more difficult.

Our paper also touches on the literature exploring the role of particular prices in determining inflation expectations. Numerous papers have highlighted that differing exposure to price signals can explain variation in consumers' inflation expectations. These differences may reflect differing consumption baskets (e.g Bürgi 2020) or variation in the specific prices people observe (e.g. Kaplan and Schulhofer-Wohl 2017; Weber, D'Acunto et al 2022; Weber, Gorodnichenko and Coibion 2022). Moreover, households tend to put higher weight on prices that appear more salient, potentially because they purchase the item more regularly (D'Acunto et al 2021), because they are more volatile (Dietrich 2024), or more generally because the price of the item is more visible to the consumer.

Finally, our paper also contributes to the broader literature trying to understand whether expectations tend to be formed using forward- or backward-looking information. We apply the framework of Brassil et al (forthcoming), which encapsulates a broad range of expectation formation mechanisms ranging from full-information rational expectations, to myopic and level-k formation (e.g. Angeletos and Lian 2018; Gabaix 2020), or adaptive learning. Beckers and Brassil (2022) apply this to union and consumer expectations. We extend their work by considering wage expectations, as well as the role of salient prices.