have found is that this relationship changes when interest rates are very low, at the so-called zero lower bound. In that situation, higher inflation expectations can encourage households to increase spending if there is alignment between experts and the public, because borrowing becomes cheaper in real terms. This can support economic activity and help the economy recover. At the other end of the scale, we also find that uncertainty about future inflation plays an important role. When inflation expectations are dispersed, meaning people strongly disagree on or feel unsure about the future, households tend to delay spending decisions, especially on durable goods. This can reduce the positive effect on the economy when the interest rates are low. WHEN IT MATTERS Divergences between experts and the public in their inflation belief come to the fore at times when monetary policy is constrained, such as during the Global Financial Crisis between 2007 and 2009, or the Covid-19 pandemic. During Covid, expectations of inflation increased significantly among the public. The belief distortion between households and experts was high. The public expected higher inflation that experts (and their data) predicted. While interest rates were at that zero lower bound, and expectations were high, so was uncertainty among the public. As a result, households adopted a more cautious stance, reducing spending and investment. Any potential boost from higher expectations was offset and recovery did not happen as it might have. A CHANGING PICTURE In normal times, belief distortion shocks are recessionary. Households usually reduce spending when they expect higher inflation, because they associate it with a worse economic outlook. This can raise inflation but also increase unemployment and inflation uncertainty. However, when interest rates are very low, this relationship can reverse, and higher inflation expectations associated with lower real interest rates, and thus better borrowing terms, can instead support spending. For this to happen, households need to trust the inflation outlooks of central banks and other experts. If they do not, and there is high uncertainty about future inflation, then the effect can weaken. For policymakers, the message is that it is not enough to keep inflation under control. It is also important to keep expectations stable and reduce uncertainty among the public. Transparent and credible communication is essential to anchor both expectations and uncertainty. Knowing about future policy can help households and firms feel more confident, making their decisions more stable and supporting the overall economy. FIFTY FOUR DEGREES | 21 Professor Lorenza Rossi is Chair in Macroeconomics in the Department of Economics at Lancaster University Management School. Belief Distortions and Uncertainty About Inflation is a CESifo working paper by Dr Stefano Fasani, of Lancaster University Management School; Giuseppe Pagano Giorgianni and Dr Valeria Patella, of Sapienza University of Rome; and Professor Lorenza Rossi, of Lancaster University Management School. l.rossi@lancaster.ac.uk
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