How do you see the state of the national economy moving forward? What are your predictions for how interest rates and inflation will behave in the months and years ahead? You may not spend every moment pondering these questions, but you will see regular news reports on the Consumer Prices Index (CPI) here in the UK, and similar mechanisms globally. They tell you how much more you are paying for goods and services than you were 12 months ago. Even if you are not consciously considering inflation, you are feeling in your pocket every time you go shopping, pay an energy bill or fill up your car with petrol. Inflation expectations play a central role in economic decisions. They influence how much money people spend, how much they save and invest. For firms, they shape wage bargaining decisions and how they set prices. While it may shape your actions, you might not think that your personal predictions matter that much in the grand scheme of things. And yet, it is precisely because beliefs affect behaviours that they matter so much. Ranks of experts in financial institutions around the world base their views on the latest data, trends, past patterns, and years of experience. But our research shows that the expectations of households when it comes to inflation are not just a reflection of the economy. They shape its path and can influence major economic dynamics such as unemployment and consumption, both positively and negatively. The extent to which this happens depends on the actual state of the economy and levels of uncertainty over inflation. For policymakers, this means that managing inflation is not only about current data, but also about guiding expectations and limiting uncertainty and disagreement among people. THE PUBLIC HAVE SPOKEN Experts and the public often interpret the economy differently. Professional forecasters rely on models, while households tend to focus on what they experience directly. One group uses a wide range of data; the sources for the other are food prices, energy bills, or rent. This matters, because these more visible factors are often more volatile than overall inflation. As a result, households may form ‘distorted’ beliefs in uncertain times. The gap between household expectations and expert forecasts can widen even when economic fundamentals do not justify it. You might see news reports of conflict in the Middle East, a pandemic emerging across the ocean, or housing bubbles bursting and economies crashing. As a result, you expect higher inflation, higher than the experts are saying will come. You change your behaviour accordingly. What happens exactly depends on the broader economic context. While it is often assumed that higher inflation expectations lead people to spend more today, there is strong evidence that households often interpret rising inflation as a signal of a worsening economic outlook, frequently associated with higher unemployment. As a result, households tend to become more cautious and reduce spending, especially on large and durable goods such as cars, kitchens, or household appliances. For example, a family might decide to postpone buying a new car or delay renovating their bathroom if they are uncertain about the future and feel that inflation is increasing because of a bad economic outlook. ONE AFFECTS ALL When many households behave this way at the same time, the effects appear at a macroeconomic level. When you see an increase in belief distortions, higher household inflation is associated with higher inflation, higher unemployment, and more disagreement about the future. This creates a situation where the economy weakens even as inflation rises. However, using US data from the Michigan Survey of Consumers and professional forecasts from the Survey of Professional Forecasters, what we 20 |
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