Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Does Inflation Uncertainty Increase with Inflation?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Does Inflation Uncertainty Increase with Inflation?

Article excerpt

One of the most important costs of inflation the uncertainty it creates about future inflation. This uncertainty clouds the decisionmaking of consumers and businesses and reduces economic well-being. Without this uncertainty, consumers and businesses could better plan for the future.

According to many analysts, uncertainty about future inflation rises as inflation rises. As a result, these analysts argue that the Federal Reserve could reduce inflation uncertainty by reducing inflation. Other analysts argue that high inflation creates no more uncertainty than low inflation, as long as inflation remains stable. As a result, these analysts argue that high inflation does not necessarily interfere with decisionmaking or reduce economic well-being.

While most previous studies have found a positive relationship between inflation and inflation uncertainty, a few key studies have not. Previous studies may be flawed, however, because they ignore a general downtrend in inflation uncertainty that has occurred over time. Reasons for the downtrend--which is independent of the level of inflation--are not well understood. Nevertheless, accounting for the downtrend is important in determining the true relationship between inflation and inflation uncertainty.

This article accounts for the downtrend in inflation uncertainty and finds unambiguous evidence that inflation uncertainty rises with inflation. The first section identifies the consequences of uncertainty about inflation and discusses some likely causes of the positive relationship between inflation and inflation uncertainty. The second section reviews the results and inconsistencies in previous research. The third section presents empirical evidence resolving these inconsistencies and pointing to a robust positive relationship between inflation and inflation uncertainty.

HOW DOES INFLATION UNCERTAINTY INTERACT WITH THE ECONOMY?

Whenever expected inflation is a factor in an economic decision, uncertainty about inflation is also likely to be a factor. For example, uncertainty about future inflation can affect both business investment decisions and consumer saving decisions. This uncertainty has adverse economic consequences that potentially rise with inflation.(1)

Consequences of inflation uncertainty

Uncertainty about inflation has two types of economic effects. First, inflation uncertainty causes businesses and consumers to make economic decisions that differ from the ones they would make otherwise. Analysts refer to these effects as ex ante, because the decisions anticipate future inflation. The second category of effects takes place after the decisions have been made, or ex post. These effects occur when inflation differs from what had been expected.

Ex ante effects. Uncertainty about inflation can affect the economy ex ante through three channels. First, inflation uncertainty affects financial markets by raising long-term interest rates. Second, inflation uncertainty leads to uncertainty about other variables that are important in economic decisions. Finally, inflation uncertainty encourages businesses to spend resources avoiding the associated risks.

The first channel through which inflation uncertainty affects the economy is by increasing long-term interest rates. An important determinant of long-term rates is the return required by investors. If inflation is uncertain, the return on nominal long-term debt will be riskier. As a result, investors will require higher expected returns, which imply higher long-term interest rates. Higher rates, in turn, imply that businesses will invest less in plant and equipment, and consumers will invest less in housing and other durable goods.

Some economists believe inflation uncertainty has been an important factor in explaining high long-term interest rates in the 1980s and 1990s. Before the high inflation of the 1970s, the spread between short-term and long-term rates was usually much lower than in recent years. …

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