Research Review | 10.14.2011 | Inflation Expectations

The Future of Inflation
Joseph G. Haubrich (Cleveland Fed) | Oct 5, 2011
To the extent that actual inflation varies more than expected inflation and expected inflation varies more than the central tendency, there is reason to think that the high rates we have been experiencing are temporary, soon to be replaced with a different cut from the deck.

Inflation Expectations and Behavior: Do Survey Respondents Act on Their Beliefs?
Olivier Armantier, et al. (NY Fed) | Aug 2011
We compare the inflation expectations reported by consumers in a survey with their behavior in a financially incentivized investment experiment designed such that future inflation affects payoffs. The inflation expectations survey is found to be informative in the sense that the beliefs reported by the respondents are correlated with their choices in the experiment. Furthermore, most respondents appear to act on their inflation expectations showing patterns consistent (both in direction and magnitude) with expected utility theory. Respondents whose behavior cannot be rationalized tend to be less educated and to score lower on a numeracy and financial literacy scale. These findings are therefore the first to provide support to the microfoundations of modern macroeconomic models.
How Flexible Can Inflation Targeting Be and Still Work?
Kenneth N. Kuttner and Adam S. Posen (Peterson Institute for Int’l Economics) | Sep 2011
After years of apparent success, inflation targeting (IT) has recently come under fire for its inability to prevent (or even its contribution to) the global financial crisis of 2008–09. The recent debate has largely centered on whether inflation targeting prevented central banks from responding sufficiently to asset price bubbles… We found no evidence to suggest that the Bank of England’s inflation target compelled it to fight inflation any more aggressively than the Fed. Inflation forecasts converge at comparable rates in both countries. The lack of any detectable asymmetry in either country between the responses to positive versus negative deviations suggest that overshooting the target has not damaged the central banks’ credibility; nor has above-target inflation elicited a disproportionately aggressive policy response. Similar results hold when comparing large versus small deviations from the target. Overall, the Bank of England seems to have been no less flexible than the Fed.
Avoiding Japan-Style Stagnation by Overcoming Bankers’ DNA
Hrishikesh D. Vinod (Fordham University) | Aug 24, 2011
This paper shows that incentive-based macroeconomic scale policy tools can be applied even when an economy is in a liquidity trap. The bankers’ DNA involving survival instinct, double entry book-keeping and inflation aversion needs to be overcome. The American economy added zero new jobs on a net basis in August 2011. The Fed is desperately trying to lower long-term interest rates. The Euro-zone is in serious trouble, while Japan remains stagnated and now unable to export her problems when the US consumer has stopped being the growth engine for the world. China continues her currency manipulation. It is obvious that the world economy faces an emergency. Bernanke et al. (2004) called for a non-standard” solution to the liquidity trap. A direct non-standard solution for the US is one-time suspension of double entry book-keeping to print” $500 billion, without creating any debit entry anywhere. The US creditors including China and Japan and the US industries sensitive to the price of imports would feel some pain. However, the pain will be worse if America were to fall into Japan-style decades long stagnation. In any case, printing money is almost painless compared to very high interest rates (20% per year in June 1981, under Fed Chairman Paul Volcker) to break the back of inflationary expectations.
How do Inflation Expectations Form? New Insights from a High-Frequency Survey
by Gabriele Galati, et al. (Bank for Int’l Settlements) | July 2011
We provide new insights on the formation of inflation expectations – in particular at a time of great financial and economic turmoil – by evaluating results from a survey conducted from July 2009 through July 2010. Participants in this survey answered a weekly questionnaire about their short-, medium- and long-term inflation expectations. Participants received common information sets with data relevant to euro area inflation. Our analysis of survey responses reveals several interesting results. First, our evidence is consistent with long-term expectations having remained well anchored to the ECB’s definition of price stability, which acted as a focal point for long-term expectations. Second, the turmoil in euro area bond markets triggered by the Greek fiscal crisis influenced short- and medium-term inflation expectations but had only a very small impact on long-term expectations. By contrast, longterm expectations did not react to developments of the euro area wide fiscal burden. Third, participants changed their expectations fairly frequently. The longer the horizon, the less frequent but larger these changes were. Fourth, expectations exhibit a large degree of timevariant non-normality. Fifth, inflation expectations appear fairly homogenous across groups of agents at the shorter horizon but less so at the medium- and long-term horizons.