Aggregate implications of heterogeneous inflation expectations: the role of individual experience

Abstract

We show that inflation expectations are heterogeneous and depend on past individual experiences. We propose a diagnostic expectations-augmented Kalman filter to represent consumers’ heterogeneous inflation expectations-formation process, where heterogeneity comes from an anchoring-to-the-past mechanism. We estimate the diagnosticity parameter that governs the inflation expectations-formation process and show that the model can replicate systematic differences in inflation expectations across cohorts in the US. We introduce this mechanism into a New Keynesian model and find that heterogeneous expectations anchor aggregate responses to the agents’ memory, making shocks more persistent. Central banks should be more active to prevent agents from remembering current shocks far into the future.

The distributional predictive content of measures of inflation expectations

“…The higher volatility in inflation expectations of the younger households is consistent with the findings in Malmendier and Nagel (2016), who document that younger people revise their expectations "more strongly" than older people in response to inflation surprises. In a similar vein, Pedemonte et al (2023) find that since the inflation surge of 2021, older individuals have higher inflation expectations, consistent with their forming their expectations by drawing on their memory of the higher inflation they experienced in the 1970s.…”

Partisan Perspectives on Inflation: Exploring Bias in Economic Expectations

“…This underscores the importance of effective central bank communication, especially in the context of recent high inflation. Pedemonte et al (2023) find that high disagreement in expectations can make shocks more persistent and more memorable, thus increasing their effect on future expectations. As a result, persistent partisan bias could exacerbate the effects of a negative shock like a high-inflationary episode.…”

“…A recently growing body of literature suggests that individual experiences influence inflation expectation formation-a significant departure from the theoretical assumption that expectations draw from objective evaluations of the economy ("full information rational expectations"). Macroeconomic modeling literature has demonstrated that heterogeneity in consumer expectations can generate over-investment in real assets (Sims, 2009) impact the economy's vulnerability to exogenous shocks (Badarinza & Buchmann, 2011), and make shocks more persistent (Pedemonte et al, 2023).…”