The Inaccuracy of Inflation Expectations

The question of whether a burst of inflation turn into permanent inflation should depend, at least in part, on expectations about inflation.

If workers and firms expect higher inflation, then the workers are more likely to press for higher wages to compensate–and firms are more likely to be amenable to such increases. An inflationary cycle can emerge where expectations of higher inflation lead to more price and wage increases, and those price and wage increases lead to higher inflation.

However, the evidence of the last couple of decades is that people’s expectations of inflation aren’t very accurate. Instead, people’s expectations often react to past rises or falls in inflation after they have happened. John O’Trakoun of the Richmond Fed gives a short overview of the evidence in “Your Attention Please …” (Macro Minute, February 5, 2022). He writes:

Historically, households have not been very good at predicting inflation. Figure 1 below plots the expected one-year inflation rate from the survey against realized Consumer Price Index (CPI) inflation a year later. Since 2007, the correlation between the two measures has been -0.35, which casts doubt on whether this survey tells us much about future inflation at all. But as we explore in this post, consumers’ expectations may now have some additional weight.

Here’s an accompanying figure. The blue line shows people’s expectations of inflation a year into the future. The red dashed line shows what inflation actually happened, but shifted back by 12 months. Thus, the right hand side of the figure shows that about a year ago, people were forecasting inflation of about 3.5% a year in the future; the red line shows that the actual rate of inflation turned out to be more like 7.5%,

There are couple of patterns worth noting in the graph. First, you can see several situations where inflation expectations change in response to earlier movements in inflation–and can end up being completely wrong. For example, the left-hand side of the graph shows how inflation expectations were rising in 2008 at about the same time that actual inflation turned out to be plummeting during the Great Recession. When people tell you what inflation they are “expecting,” it often looks as if they are actually telling you what inflation they recently experienced. Second, you can see that for most of the decade from 2010 to 2020, inflation expectation just didn’t change much, even when actual inflation fell and then rose. A plausible interpretation here is that many people haven’t paid much attention to inflation for the last decade.

Thus, one possibility is that inflation expectations don’t much match inflation when people aren’t much paying attention, and when inflation is fluctuating in a fairly narrow range. But if inflation stays higher for a significant time, in a way that is salient to many people, then the chance that current inflation expectations feeding into future inflation become higher.