"Real-Feel" Inflation: Quantitative Estimation of Inflation Perceptions

By Ashton, Michael J. | Business Economics, January 2012 | Go to article overview

"Real-Feel" Inflation: Quantitative Estimation of Inflation Perceptions


Ashton, Michael J., Business Economics


Inflation expectations are believed to influence actual inflation and therefore policymaker actions. However, methods usually employed to evaluate inflation expectations are insufficient. Survey methods either record economists' forecasts of the official Consumer Price Index (CPI) (which isn't what policy makers need to know) or consumers' attempts to calculate their own inflation experience. Consumers have little chance to perform the calculations needed to accurately compute inflation. I propose functional forms to substitute for the heuristics consumers actually use to form inflation perceptions. I also propose adjustments to reconcile official price measurements with consumers' perceptions. These adjustments are corrections for cognitive biases related to loss aversion and mental accounting. Business Economics (2012) 47, 14-26.

doi: 10.1057/bc.2011.35

Keywords: inflation perceptions, inflation expectations, inflation

Modern monetary policy considers inflation expectations a metric of signal importance in the formulation of monetary policy. While the Taylor Rule [Taylor 1993] provides a well-known heuristic for monetary policy makers that relies on actual, not expected inflation, policy discussions rely heavily on the question of whether inflation expectations are. and will continue to be, ''contained." (See, for example, selected statements of the Federal Reserve Open Market Committee (FOMC) [Board of Governors 2006, 2008, and 2010].) Current Federal Reserve Chairman Ben Bernanke [2007] himself described the importance and significance of inflation expectations in a speech by saying "Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price Stability" [Bernanke 2007].

In that speech, Bernanke highlights three important questions that remain to be addressed about inflation expectations:

(1) How should the central bank best monitor the public's inflation expectations?

(2) How do changes in various measures of inflation expectations feed through to actual pricing behavior?

(3) What factors affect the level of inflation expectations and the degree to which they are anchored?

According to Bernanke, the staff at the Federal Reserve struggle with even the first of these questions, although this has not deterred them from tackling the second and third questions.

Frederic Mishkin [2007] described recent changes in the persistence of inflation, the tradeoff between inflation and unemployment, and the responsiveness of inflation to other shocks as a function of well-grounded inflation expectations. To proxy inflation expectations he used the Livingston Survey of the Federal Reserve Bank of Philadelphia and the measure used in the Federal Reserve's FRB/US macroeconometric model of the United States, which itself consists of the Hoey survey (1) and the Survey of Professional Forecasters (SPF), He also referred to the Michigan Survey of Consumer Attitudes and Behavior (Michigan survey). Levin, Natalucci, and Piger [2004] also examined the response of survey measures of the inflation expectations of professional forecasters to near-term changes in actual inflation rates, begging the question of whether the expectations of forecasters, much less a survey of such expectations, are valuable measures themselves.

Mankiw, Reis, and Wolfers [2003] compared survey measures of inflation, including the aforementioned Livingston survey, the SPF, and the Michigan survey. They illustrated that both consumers and economists tend to be broadly correct about near-term future inflation, on average, but that economists tend to have tightly grouped estimates, while consumers have very dispersed views; in the year to December 2003 (their Chart 2), economist estimates generally fell between 1 1/2 and 3 percent while the interquartile range of consumer expectations lay between 0 and 5 percent. …

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