Inflation Expectations and Their Formation: Working Paper 2022-03

By Jeffrey Schafer.

This paper reviews theory and evidence on how consumers and firms form their expectations about inflation and how monetary policymakers might influence that process; both of those factors have implications for the Congressional Budget Office's baseline projections and policy analyses.

Inflation expectations are important because they affect decisions that determine actual inflation. Surveys of consumers and business managers provide especially useful data for studying the process of forming expectations. Empirical evidence suggests that economically meaningful information frictions exist in the process of forming expectations and that the structure of those information frictions is such that realizing more persistent inflation or increasing the incentive to collect information on inflation—perhaps as the result of ongoing supply disruptions, such as the ones precipitated by the coronavirus pandemic—would reduce them.

There is also empirical evidence of substantial biases in individual-level inflation forecasts, which possibly amplify trends in the realized inflation data. Surveys reveal that, before the onset of the pandemic, firm managers did not pay much attention to aggregate inflation dynamics and were not well informed about the objectives or actions of monetary policymakers. If the observed level of information frictions decreased enough at the same time that individual decisionmakers' inflation forecasts continued to amplify trends in the realized inflation data, then aggregate measures of inflation expectations might begin to amplify those trends as well.