Expectation Formation Process Research Articles

What Do (and Don't) Forecasters Know About U.S. Inflation?

AbstractThis paper contributes to and extends our current understanding of information frictions in expectations. I first propose a new framework for estimating noisy information using individual forecasts. I further extend this framework to incorporate misperceptions on the part of economic agents about the persistence of the underlying process being forecasted. Applying this framework to the U.S. inflation, forecasts of professional forecasters suggest a systematic overestimation on the part of forecasters of the persistence of inflation in addition to the presence of noisy signals. Using a structural model that incorporates both noisy signals and misperceptions of persistence, I quantify the relative importance of each channel in accounting for the expectations formation process of these agents. The results indicate that, even for professional forecasters, there are multiple forces that generate economically significant deviations from full information.

Diligent forecasters can make accurate predictions despite disagreeing with the consensus

We follow the sticky information framework and derive two novel model implications that both ex-ante forecast disagreement and ex-post forecast accuracy are associated with the degree of information stickiness at an individual level. Using micro-level forecast data from the G7 countries, we show that professional forecasters are persistently heterogeneous. More importantly, we find supportive evidence that forecast accuracy is negatively associated with information stickiness, while forecast disagreement increases at a slowing rate as individual information stickiness increases. The relationship between forecast disagreement and individual information stickiness is also affected by the degree of average information stickiness and the persistence of target macroeconomic variables. This paper contributes to the literature by providing theoretical linkages between the heterogeneous expectation formation process and information stickiness at an individual level.

Identifying the source of information rigidities in the expectations formation process

Coibion and Gorodnichenko (2015) provide a useful framework to test the null hypothesis of full-information rational expectations against two popular classes of information rigidities, sticky information (SI) and noisy information (NI). However, the observational equivalence of SI and NI in average forecast errors gives no power in the test for one against the other. We identify the source of information rigidities by estimating the equations for the average forecast errors and variance of forecasts. The results show the importance of both SI and NI, but favor a type of NI in which agents can quickly learn the underlying state.

An Estimated Model of Household Inflation Expectations: Information Frictions and Implications

Abstract This paper proposes and estimates a dynamic model of household inflation expectations with information frictions and time-varying parameters, where households use a Bayesian learning model to form and update inflation expectations. The model decomposes households' inflation expectation formation process into a learning component, a noisy signal component, and a measurement component. Model-implied household inflation expectations provide a robust fit for the expectation-augmented Phillips curve. As a result of time-varying inflation dynamics, households' attention to inflation is endogenous to its volatility. This insight offers explanations for the anchoring of inflation expectations during the Great Moderation.

The reaction of disagreements in inflation expectations to fiscal sentiment obtained from information in official communiqués

AbstractUsing official communiqués about fiscal policy, we develop a fiscal sentiment indicator, and we verify the reaction of disagreements in inflation expectations to fiscal sentiment. This analysis is relevant to inflation targeting (IT) countries because transparency and communication can influence expectations. The results suggest that a more optimistic fiscal sentiment reduces disagreements in inflation expectations. Estimates show that, for higher disagreements in inflation expectations at 12‐month maturity, an optimistic fiscal sentiment can reduce the disagreement more sharply. In turn, the fiscal sentiment effect on the disagreement for the 48‐month maturity is stronger the smaller the disagreement is. The results allow us to outline the following policy recommendations. First, an optimistic fiscal environment is important in the task of guiding inflation expectations and reducing inflation uncertainty. Second, fiscal communication is an important tool for the expectations formation process, and therefore it must be carefully managed to help in the task of forward guidance of inflation expectations, being important for the IT regime. Third, both fiscal credibility and monetary policy credibility are important for the expectations formation process, particularly for the reduction of inflation uncertainty, representing aspects that must be preserved in countries that adopt the IT regime.

The Inadequacies of Utility Theory from a Macroeconomic Modelling Perspective

The paper briefly draws on the work of Marx and Keynes to question the contribution that utility theory has made to Macroeconomics. Contemporary utility-theoretic developments (in Growth Theory and Behavioural Economics) are also examined from a Post-Keynesian, Macroeconomic-Modelling perspective and are found to be wanting. First and foremost, we discuss the implications of using representative agent models in a single good (i.e., corn model) context. In these “Robinson-Crusoe” models, the corn uneaten automatically becomes the seed corn planted in the ground and, through her choices, the consumer-farmer-investor implicitly determines the corn's own rate-of-return (interest rate) that ensures optimal production. As such, any departures from full utilisation of capacity and labour can only be the temporary result of optimal though costly processes of adjustment. Macroeconomic behaviour and outcomes that are still not adequately explained by more complex models include: (1) the existence of very high average propensities to save for wealthy households; (2) the phenomenon of liquidity preference, which explains the desire to hold money on the part of investors and determines short-run equilibrium in the market for both real and financial assets while providing a partial explanation for obstructions within the monetary circuit. In this context, it is argued that the process of expectations-formation is best seen as something that is fragile, contingent, and potentially subject to dramatic revision.

Monetary Policy Uncertainty and Inflation Expectations*

AbstractDo inflation expectations react to changes in the volatility of monetary policy? They have, but only until the global financial crisis. This paper investigates whether increasing the dispersion of monetary policy shocks, which is interpreted as elevated uncertainty surrounding monetary policy, affects the inflation expectation formation process. Based on US data since the 1980s and a stochastic volatility‐in‐mean structural VAR model, we find that monetary policy uncertainty reduces both inflation expectations and inflation. However, after the Great Recession this link has disappeared, even when controlling for the Zero Lower Bound.

The Role of the Media in the Inflation Expectation Formation Process

This research highlights the role played by the media in the formation of inflation expectations among various respondents in Ukraine. Using a large news corpus and machine-learning techniques, I have constructed newsbased metrics that produce quantitative indicators for texts, which show if the news topics are relevant to inflation expectations. I have found evidence that various news topics may have an impact on inflation expectations, and can explain part of their variance. Thus, my results could help in the analysis of inflation expectations – which is of value, given that anchoring inflation expectations remains a key challenge for central banks.

Experience of shocks, household wealth and expectation formation: Evidence from smallholder farmers in Kenya

AbstractWhen faced with uncertain events, decision‐makers form expectations about the events’ likelihood of occurrence. However, the drivers and moderators of such expectations are still poorly understood, especially for farm decision‐makers in developing countries whose incomes are very risky by nature. This article analyses the dynamic shock expectation formation process of farmers in Kenya with regard to a range of shock events using a unique panel dataset. The results suggest that farmers are more likely to update their expectation regarding a specific adverse shock when they have recently been affected by that shock or by more shocks in general. In case of price shocks, farmers are also more likely to update expectations when a larger proportion of fellow village members was affected. However, household wealth moderates the relationship between shock expectation and experience, such that wealthier households are less likely to update their expectations following a shock. A better understanding of the drivers of expectation formation can help in the design of better risk management instruments that increase farmers’ resilience.

Monetary policy, rational confidence, and Neo‐Fisherian depressions

AbstractWhy do economies fall into depression equilibria with output and inflation below target? What is the appropriate monetary policy? We examine the so‐called “Neo‐Fisherian” claim that, at the zero lower bound of the policy interest rate, and the economy in a depression equilibrium, in order to restore the desired inflation rate the policy rate should be raised consistently with the Fisher equation. To this end, we study a New Keynesian economy where we introduce a process of expectations formation, less explored in the relevant literature, such that agents, facing multiple equilibria, seek to figure out their subjective probabilistic beliefs about the future long‐run equilibrium of the economy (“normality”, with inflation and output reverting to target, or “depression”, with inflation and output remaining below target), driven by the observed state of the economy. Therefore, key to the macroeconomic process is the dynamic interaction between the agents' state of confidence in the return to normality and monetary policy. Differently from comparable works, we find that the Neo‐Fisherian claim is a theoretical possibility depending on the interplay of a set of parameters and very low levels of agents' confidence. Yet, on the basis of simulations of the model, we may say that this possibility is remote for most commonly found empirical values of the relevant parameters. Moreover, the Neo‐Fisherian policy‐rate peg is not sustained by the expectations formation process.

Yield curve reactions to fiscal sentiment in Brazil

PurposeUsing a fiscal sentiment indicator, this study aims to verify whether fiscal sentiment affects the yield curve in Brazil. Since policymakers highlight the coordination between monetary and fiscal policies and the importance of fiscal policy to the expectations formation process in inflation targeting regimes, the authors also explore the transmission mechanism through inflation expectations. Hence, the study also analyzes the effect of fiscal sentiment on interest rate swap spreads through the inflation expectations channel.Design/methodology/approachBased on information obtained from official communiqués about fiscal policies issued by the Central Bank of Brazil and the Brazilian Ministry of Finance, the study builds a fiscal sentiment indicator. The econometric strategy to verify whether fiscal sentiment is related to the short tail of the yield curve is based on time series analysis through ordinary least squares and generalized method of moments estimates. In turn, to estimate the transmission mechanism through inflation expectations, the model uses interaction terms between fiscal sentiment and inflation expectations.FindingsThe results suggest a more optimistic (pessimistic) fiscal sentiment reduces (increases) swap spreads. The findings reveal that improvements in fiscal credibility and a more optimistic fiscal sentiment are able to reduce the positive marginal effect that inflation expectations variations have on interest rate swap spreads.Originality/valueThis study contributes to the literature, as, to the best of authors’ knowledge, it is the first to analyze the content of the communiqués related to fiscal policy, and based on this content, it extracts the sentiment related to the fiscal environment and analyzes the effect of this sentiment on the yield curve. Besides, different from existing studies that analyze the effect of fiscal backward-looking aspects (such as public debt, budget balance, taxes and public spending) on the yield curve, this study investigates forward-looking aspects related to fiscal policy (such as fiscal credibility and fiscal sentiment).

Macroeconomic dynamics under bounded rationality: on the impact of consumers’ forecast heuristics

This paper considers various types of forecast heuristics to examine the effects of boundedly rational agents on macroeconomic dynamics. Given the baseline New Keynesian model, we seek to find the expectation formation process that is most suitable in describing economic adjustments over the business cycle. In particular, impulse response analysis is used to compare the performances of the macroeconomic model under bounded rationality and under rational expectations. The results show that the fluctuations in consumer confidence mainly explain the degree of persistence in consumption. We conclude that a model under bounded rationality with a heuristic-induced switching process can qualitatively provide a good fit to the data that is equivalent to a model under rational expectations.

Pricing Process in Mexico: New Evidence on the Inflation Dynamics

We analyze the inflation dynamics in Mexico during inflation targeting period by a GMM estimate of the Hybrid New Keynesian Phillips Curve in its open and closed economy versions. We update and discuss previous results and expand the capacity of this tool to analyze inflationary dynamics by incorporating the exchange rate on labor costs. We find: a) robust evidence of adaptive and rational expectations; b) incorporating the exchange rate improves the inflation fit; c) this version of the Phillips Curve has strengthened since Great Recession, and e) expectations formation process changes during inflationary episodes according to the origin of shocks.

Disciplining expectations and the forward guidance puzzle

Forward guidance operates via the expectations formation process of the agents in the economy. In standard quantitative macroeconomic models, expectations are unobserved variables formed endogenously via the dynamics of the model and little scrutiny is devoted to analysing the behaviour of these expectations. We show that the introduction of survey and financial market-based forecast data in the estimation of the model disciplines the expectations formation process in DSGE models. When the model-implied expectations are matched to observed expectations, the additional information of the forecasts restrains the agents’ expectations formation. We argue that the reduced volatility of the agents’ expectations dampens the model reactions to forward guidance shocks and improves the out-of-sample forecast accuracy of the model. Furthermore, we evaluate the case for introducing a discount factor as a reduced form proxy for a variety of microfounded approaches, proposed to mitigate the forward guidance puzzle. Once data on expectations is considered, the empirical support to introduce a discount factor dissipates.

Identifying the Source of Information Rigidities in the Expectations Formation Process

Coibion and Gorodnichenko (2015) provide a useful framework to test the null hypothesis of full-information rational expectations against two popular classes of information rigidities, sticky information (SI) and noisy information (NI). However, the observational equivalence of SI and NI in average forecast errors gives no power in the test for one against the other. We identify the source of information rigidities by estimating the equations for the average forecast errors and variance of forecasts. The results show the importance of both SI and NI, but favor a type of NI in which agents quickly learn the underlying state.

The role of production method information on sensory perception of smoked salmon—A mixed-method study from Denmark

Product information is capable of steering the consumers’ expectation formation process. Therefore, this paper aims to investigate whether information on production method influence consumers’ preference and liking of smoked salmon. A consumer test was conducted among 92 consumers to determine liking of the smoked salmon on a 7-point hedonic scale before (blind) and after (informed) receiving information about production method (organic, conventional and wild-caught). Further, two explanatory focus group discussions (n = 5 in each group) were conducted to determine consumers’ belief on production method.A linear mixed-effects model analysis indicated that the consumer overall liking of wild-caught smoked salmon significantly increased after production method information was provided, while regarding organic and conventional smoked salmon no significant difference was noted. Post hoc test indicated that organic smoked salmon was significantly more liked than wild-caught smoked salmon (mean difference ± standard error: 0.652 ± 0.19, p < 0.01) in blind condition, however, between organic and conventional smoked salmon no significant difference was noted (-0.032 ± 0.19, p = 0.983). Further, in informed condition, organic smoked salmon was significantly more liked than conventional smoked salmon (0.50 ± 0.19, p < 0.05), however, between organic and wild-caught smoked salmon no significant difference was noted (0.228 ± 0.19, p = 0.452). Relative importance analysis results suggest that liking of taste was the most important contributor (26.84%) to smoked salmon overall liking (p < 0.05, R2 = 74.17%). Focus group discussion revealed that consumer beliefs related to food safety, animal welfare and sustainability as well as purchasing habits seem to influence smoked salmon preferences.Thus, organic aquaculture sector should focus on promoting consumer beliefs by providing reliable information based on scientific evidences that helps differentiates their products with that of conventional and wild-caught smoked salmon. Future studies might investigate other fish species to better understand the role of product method information on consumer preference and liking of fish.

Identifying the source of information rigidities in the expectations formation process

Coibion and Gorodnichenko (2015) provide a useful framework to test the null hypothesis of full-information rational expectations against two popular classes of information rigidities, sticky information (SI) and noisy information (NI). However, the observational equivalence of SI and NI in average forecast errors gives no power in the test for one against the other. We identify the source of information rigidities by estimating the equations for the average forecast errors and variance of forecasts. The results show the importance of both SI and NI, but favor a type of NI in which agents quickly learn the underlying state.

İktisadi Beklentiler ve Karar Almada Deneyimsel ve Bilişsel Süreçler

In the process of forming expectations and decision-making, how brain processes internal and external information and experiences and the factors are affecting these processes are an important discussion. In this context, the relationship between an agent’s emotions and rational reasoning ability and that between expectation formation and decision-making process are important. In the mainstream economic literature, expectation and decision-making theories are formed by perspectives reliant on the cognitive aspects of these processes. However, such perspectives do not explain the relationship of emotions and affect with intuitive and experiential systems. In this respect, the relationship between the experiential system and the rational system must be analyzed. They are expressed in metaphors of mind and emotion in psychology, cognitive neuroscience, and behavioral economics literature, which should be included more intensively in economic methodology. The dual-process theories applied in the field of psychology work on the information processing and thinking systems of an individual. The distinction and interdependence between the rational reasoning of the brain and the experiential process of information processing, especially those of the dual-process theories, show that the framework of economic expectations and established theories of decisionmaking is insufficient to understand the process of forming those processes. To overcome this important deficiency in economic literature, it is concluded with the help of related literature that emotions affect the expectation and decision-making formation and that the experiential process in the brain works in a manner that works together collaboration with the rational system.

Expectation formation following pandemic events

Previous studies find that the degree of information rigidity is negatively associated with natural disaster shocks, recessions, and high economic uncertainty, suggesting that the expectation formation process is state dependent. Matching a large panel data of macroeconomic forecasts to the pandemic data, this letter shows that the degree of information rigidity declines significantly following pandemic events, confirming that the expectation formation process is also driven by unexpected health shocks.

Conditional Macroeconomic Forecasts: Disagreement, Revisions and Forecast Errors

Using data from the European Central Bank's Survey of Professional Forecasters, we analyze the role of ex-ante conditioning variables for macroeconomic forecasts. In particular, we test to which extent the heterogeneity, updating and ex-post performance of predictions for inflation, real GDP growth and the unemployment rate are related to assumptions about future oil prices, exchange rates, interest rates and wage growth. Our findings indicate that inflation forecasts are closely associated with oil price expectations, whereas expected interest rates are used primarily to predict output growth and unemployment. Expectations about exchange rates and wage growth also matter for macroeconomic forecasts, albeit less so than oil prices and interest rates. We show that survey participants can considerably improve forecast accuracy for macroeconomic outcomes by reducing prediction errors for external conditions. Our results contribute to a better understanding of the expectation formation process of experts.