Disagreement and Biases in Inflation Expectations

Abstract

Empirical work documents substantial disagreement in inflation expectations obtained from survey data. Furthermore, the extent of such disagreement varies systematically over time in a way that reflects the level and variance of current inflation. This paper offers a simple explanation for these facts based on asymmetries in the forecasters' costs of over-and under-predicting inflation. Our model implies biased forecasts with positive serial correlation in forecast errors and a cross-sectional dispersion that rises with the level and the variance of the inflation rate.It also implies that forecast errors at different horizons can be predicted through the spread between the short-and long-term variance of inflation. We find empirically that these patterns are present in inflation forecasts from the Survey of Professional Forecasters. A constant bias component, not explained by asymmetric loss and rational expectations, is required to explain the shift in the sign of the bias observed for a substantial portion of forecasters around 1982.

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