Formation of Inflation Expectations in British Manufacturing Industries

Abstract

Over the past decade increasing use has been made of direct information on price expectations in empirical studies of the expectations formation process. In the United States, Livingston's inflation expectation series have been extensively analysed by Turnovsky (I970), Turnovsky and Wachter (I972), Pesando (I975), McGuire (I976), Carlson (I977), Mullineaux (I978, I980), Jacobs and Jones (I980), Figlewski and Wachter (I98I) and others. In the United Kingdom, the general public expectations of consumer prices made available in the Gallup polls have been studied by Carlson and Parkin (I975), Holden and Peel (I977), Smith (I982), Severn (1983) and Evans and Gulamani (I984). Similar studies have also been carried out with respect to surveys conducted in Germany, France and most other OECD countries. However, despite the apparent importance of businessmen's expectations for the understanding of the inflationary process, the empirical research on inflation expectations in the United Kingdom has been mainly concerned with the consumers' price expectations.' The present paper is an attempt to rectify this shortcoming by extending the empirical analysis of the inflation expectation process to British manufacturing industries using the results of the industrial trend surveys conducted by the Confederation of British Industries (CBI). The plan of the paper is as follows: Section I deals with the methodological problems of deriving quantitative inflation expectations series from qualitative responses such as the ones reported in the CBI surveys. The subjective probability method due to Theil, Carlson and Parkin, and the regression method recently proposed by the author (Pesaran, I984) for the conversion of categorical responses to quantitative measures are briefly discussed. Section II sets out the alternative models of inflation expectations formation. Section III describes the data on inflation expectations in British manufacturing industries, and discusses the forecasting value of alternative measures of inflation expectations. Section IV focuses on the issue of measurement errors in expectations and the econometric problems involved. Section V reports the results of estimation of alternative models of inflation expectations, and investigates the quantitative impact of government policy and general economic conditions on inflation