Interest rate movements and US consumers’ inflation forecast errors: is there a link?

Abstract

The Fisher effect maintains that movements in short-term interest rates largely reflect changes in expected inflation. Since expected inflation is subject to error, we ask whether interest rates move in response to over- and under-predictions of inflation. In answering, we measure expected inflation by the consumers’ forecast of inflation derived from the Michigan Surveys of Consumers (MSC). Our findings for 1978–2013 indicate that the MSC inflation forecasts were unbiased, efficient, and directionally accurate. For 1978–2007, (i) interest rates moved downward (upward) in response to MSC over-predictions (under-predictions) of inflation, and (ii) MSC inflation forecast errors had directional predictability for interest rates. However, no link between interest rate movements and MSC inflation forecast errors is detected for 2008–2013 when monetary policy kept short-term interest rates unusually low.