Do we expect too much from expectations?

Posted by: Paul Donovan

01 Nov 2019
  • Inflation expectations are a focus in financial markets. We often hear that "inflation expectations are too low" for a central bank to raise rates. But do inflation expectations matter?
  • Consumers are bad at forecasting inflation. Consumers remember the prices of things that they buy often. They forget the prices of things that they buy less often. Consumers also tend to think that inflation today will be the same in the future. This means that a consumer's expectation of future inflation is strongly tied to the price of food and energy today. The price of food and energy today is not a very good predictor of inflation in the future. This makes consumers bad predictors of future inflation.
  • Should investors care about inflation expectations? Expectations matter if they change behavior. If consumers (wrongly) think inflation is high, they might try and get large pay increases. Pay increases matter to costs, profits, and inflation. Consumers may cut spending if they (wrongly) believe inflation is high. When inflation expectations are low, the reverse is likely.
  • Policy makers and investors should not worry too much about where consumers think inflation is going. Consumers will be wrong. They should worry about how consumers respond to those expectations.

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