Household inflation expectations feature prominently in current central bank policy discussions. This column summarises key insights from the recent literature on household inflation expectations for the conduct of monetary policy. First, households appear to act on their beliefs about inflation, yet often in heterogeneous and context-dependent ways. Second, household inflation expectations present significant deviations from traditional assumptions about rationality in expectations formation. Still, central bank communication is important, and information about the price stability target can help anchor consumer expectations more closely to the central bank objective.
Central banks today continue to grapple with the aftermath of the surge in global inflation that arose in the wake of the pandemic and the Russian invasion of Ukraine. In charting the course of monetary policy, they pay close attention to many indicators, and they have stressed the importance of a data-driven approach (e.g. Lagarde 2024) in making sure that they achieve their inflation targets. In this column, we shine the spotlight on one set of data that has featured prominently in current central bank and monetary policy discussions, namely, the measures of household inflation expectations, in which many central banks have invested heavily in recent times (see Coibion et al. 2018, Lane 2021, Shleifer 2019). We try to distil some of the insights for monetary policy drawing on an explosion of research related to such measures particularly over the past ten years (D’Acunto et al. 2024). To do so, we focus on three broad questions: (i) Do household inflation expectations really matter for economic outcomes?, (ii) Are these expectations well-anchored around the central bank inflation target?, and (iii) Are there likely to be benefits for central banks from enhanced communication with consumers?
Do household inflation expectations matter for economic outcomes?
One important reason to study consumers’ subjective expectations about inflation is that such beliefs may explain household choices and decisions, thus providing a more coherent account of economic fluctuations, also at an aggregate level (Coibion et al. 2020). A broad emergent conclusion from recent research in this area is that households indeed appear to act on their beliefs about inflation, yet often in heterogeneous and context-dependent ways. A considerable amount of evidence has emerged showing a causal response of consumption to higher expectations of future inflation, in line with the role that economists typically assign to the real interest rate in business cycle propagation and monetary transmission.
Figure 1 Impact on consumption
For example, Figure 1 Panel A depicts the results from D’Acunto et al. (2022) who examine a rise in inflation expectations in Germany that resulted from a pre-announced VAT increase in November 2005 (that was implemented about one year later in January 2007). The result was a very salient and well understood temporary increase in expected inflation in Germany. The findings show that the rise in expected inflation had a sizeable and macroeconomically relevant positive impact on spending on durables. In general, the inflation-spending nexus is however heterogeneous across the population, driven by more educated, higher IQ, and financially literate consumers, as well as stronger after policy measures whose design and communication emphasise the economic relationship between inflation and the consumption-saving decision (see also D’Acunto and Weber 2024).
The above results are nonetheless context-dependent, with some other studies (Candia et al. 2020, Coibion et al. 2023) showing that consumption may respond negatively to higher expected inflation, especially if it signals a drop in expected future real incomes. The more recent bout of higher inflation expectations in the euro area may represent a good example of these contractionary or stagflationary effects. For example, Figure 1 Panel B suggests that the persistent rise in inflation expectations between February 2022 and October 2023 was also associated with a rising share of consumers anticipating negative economic growth and a worse financial situation for their own households. These conflicting results also point to the potentially important role of broader consumer narratives (e.g. Andre et al. 2022) or sentiment in driving the causal relation between spending and inflation expectations. For example, an expected increase in future inflation may represent a signal of bad economic news in the future and, hence, it may engender more precautionary behaviour (Coibion et al. 2024). On the other hand, if such an increase in expected inflation is associated with a positive narrative (e.g. ‘the economy is expected to grow strongly in the future’), it may lead to more spending and less precautionary behaviour.
How well-anchored are household inflation expectations?
Central bankers traditionally believe that it is desirable to maintain inflation expectations ‘well-anchored’ and close to the inflation target (e.g. Bernanke 2007). According to this logic, well-anchored inflation expectations help to reduce the persistence of shocks to actual inflation and thus help mitigate the risk of either an inflationary or a deflationary spiral. Expectations at medium-run horizons are often seen as the most relevant when it comes to discussions about anchoring, because central banks typically define their price stability objective to be achieved over the medium term.
An important insight from the recent research programme on household inflation expectations is that these expectations are not well-anchored around central bank targets. A large amount of disagreement amongst consumers is present, which is linked to deviations from traditional assumptions about rationality in expectation formation (e.g. D’Acunto and Weber 2024). Household inflation expectations are highly subjective, reflecting consumers’ own personal price exposures, their selective recall of particularly salient prices like food or energy, how frequently and even who in the household is doing the grocery shopping (e.g. Braggion et al. 2023, Wehrhöfer 2024). Many consumers mechanically extrapolate or overreact to idiosyncratic news about inflation but underreact to more aggregate news such as information about monetary policy and aggregate demand. The evidence points to quite low interest in and attention to news about inflation, especially from official sources (Weber et al. 2023). However, such attention is time-varying and higher in times of high inflation (see Weber et al. 2024). These results call for incorporating information frictions and heterogeneity into the models that central banks use for policy and risk analysis (e.g. Meeks and Monti 2024).
Figure 2 Co-movement of short-term and longer-term inflation expectations
Source: ECB Consumer Expectations Survey (CES), ECB Survey of Professional Forecasters (SPF) and authors’ calculation.
Notes: Binscatter plot of the pooled February 2022 to December 2023 data. The Figure depicts variation in expectations within individuals over time by means of a fixed-effects regression. Inflation news is measured as the within individual variation of consumers’ one-year forecast of inflation. Five-year ahead inflation expectations are currently collected every month on experimental basis in the ECB CES.
Figure 2 provides an illustration of this extrapolative behaviour and the imperfect anchoring of consumers’ inflation expectations for the case of the euro area. It shows how consumers’ three-year and five-year ahead inflation expectations are much more sensitive to short-term inflation news, as compared to those of professional forecasters which remain stable at central bank targets even when there is a substantial revision in short-term expectations. This imperfect anchoring of consumers’ medium- and long-run inflation expectations poses challenges for monetary policy analysis and communication (Ehrmann et al. 2023). When confronted with a noticeable rise in consumers’ medium-run expectations, central bankers need to figure out whether this rise may represent an overreaction of consumers to current price signals which is likely to subsequently self-correct or, alternatively, if it may represent a more genuine shift in medium-run risks to price stability to which policy might need to respond.
Figure 3 Likelihood that the ECB delivers price stability over the medium-term (three years)
Treatment effect on ECB credibility, in percentage points
Source: Ehrmann et al. (2023) based on the ECB Consumer Expectations Survey.
Notes: The Figure depicts the treatment effects (with 95% confidence intervals) on the ECB’s credibility to achieve price stability over the next three years.
Are there likely benefits from enhanced communication with consumers?
While household inflation expectations likely respond only very sluggishly to monetary policy changes, recent research has emphasised the potential of central bank communication in influencing households’ inflation expectations more directly. Such communication efforts require significant investment by central banks because consumers are very difficult to reach, and monetary policy – in trying to catch consumers’ attention – must compete with many other likely more pressing concerns and interests. According to evidence in Ehrmann et al. (2023), about 30% of euro area consumers say they are ‘not much’ or ‘not at all’ interested in monetary policy. However, one particularly important insight is the importance of communicating about the price stability target, which can help coordinate consumers’ beliefs about future inflation and anchor them more closely around the central banks’ objective. For example, as depicted in Figure 3, communicating about the ECB’s symmetric 2.0% inflation target and providing an explanation about the stabilising role of monetary policy gives rise to a significant increase in the probability that consumers assign to the prospect of price stability over a three-year horizon. Recent literature has also emphasised the importance of diverse policy committees in helping to reach certain population segments. For example, research for the US economy has shown that reflecting different identities (e.g. gender, race, etc.) in central bank policy committees and in policy communication could increase trust in specific and otherwise underrepresented and hard-to-reach subgroups of the population and thereby also enhance the overall effectiveness of monetary policy (D’Acunto et al. 2021). Looking forward, the exploration of the benefits of such diversity in the multi-country and multi-cultural context of the euro area would represent an important priority for future research.
Wrapping up: Many open issues reflecting the complexity of household expectations formation
The past decade has seen a resurgent interest in direct survey measures of inflation expectations for households. This trend has been supported by advances in survey design and more widespread internet penetration which have enabled direct measurement of subjective beliefs about the economy using online surveys (Georgarakos and Kenny 2022). The resulting measures of inflation expectations have revealed considerable complexity and large deviations from the more traditional assumptions about rationality in expectations formation. However, central banks and academic researchers have begun to embrace the analysis of this complexity and, while much more needs to be done, this effort is already leading to new advances in the understanding of business cycles, monetary policy transmission, and the effectiveness of central bank communication.
Source : VOXeu
