DP15624 The People versus the Markets: A Parsimonious Model of Inflation Expectations

Author(s): Ricardo Reis
Publication Date: January 2021
JEL(s): D84, E31, E52
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15624

Expected long-run inflation is sometimes inferred using market prices, other times using surveys. The discrepancy between the two measures has large business-cycle fluctuations, is systematically correlated with monetary policies, and is mostly driven by disagreement, both between households and traders, and between different traders. A parsimonious model that captures both the dispersed expectations in surveys, and the trading of inflation risk in financial markets, can fit the data, and it provides estimates of the underlying expected inflation anchor. Applied to US data, the estimates suggest that inflation became gradually, but steadily, unanchored from 2014 onwards. The model detects this from the fall in cross-person expectations skewness, first across traders, then across people. In general equilibrium, when inflation and the discrepancy are jointly determined, monetary policy faces a trade-off in how strongly to respond to the discrepancy.