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The Hidden Heterogeneity of Inflation Expectations and its Implications

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07/10/2020 | 10:16am EDT

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

The Hidden Heterogeneity of Inflation Expectations and its

Implications

Lena Dr¨ager, Michael J. Lamla, and Damjan Pfajfar

2020-054

Please cite this paper as:

Dr¨ager, Lena, Michael J. Lamla, and Damjan Pfajfar (2020). "The Hidden Hetero-geneity of Inflation Expectations and its Implications," Finance and Economics Discus-sion Series 2020-054. Washington: Board of Governors of the Federal Reserve System,https://doi.org/10.17016/FEDS.2020.054.

NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

The Hidden Heterogeneity of Inflation Expectations and its

Implications

Lena Dra¨gerMichael J. Lamla Damjan Pfajfar§

July 2, 2020

Abstract

Using a new consumer survey dataset, we document a new dimension of heterogeneity in infla-tion expectations that has implications for consumption and saving decisions as well as monetary policy transmission. We show that German households with the same inflation expectations dif-ferently assess whether the level of expected inflation and of nominal interest rates is appropriate or too high/too low. The 'hidden heterogeneity' in expectations stemming from these opinions is related to demographic characteristics and affects current and planned spending in addition to the Euler equation effect of the perceived real interest rate. Furthermore, these differences in opinions affect German households differently depending on whether they are renters or home-owners.

Keywords: Macroeconomic expectations, monetary policy perceptions, survey microdata.

JEL classification: E31, E52, E58, D84.

We would like to thank participants at the American Economic Association Meeting, the TU Dresden and Joint Deutsche Bundesbank and Bank de France Conference on Household Expectations for their comments. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Board.

Leibniz University Hannover. Email:draeger@gif.uni-hannover.de.

Leuphana University of Lu¨neburg and ETH Zurich, KOF Swiss Economic Institute. Email:michael.lamla@leuphana.de.

§Board of Governors of the Federal Reserve System. Email:damjan.pfajfar@frb.gov.

I

1 Introduction

In recent years, a large literature has developed that focuses on the formation of consumers' macroe-conomic expectations. Phenomena such as the tendency of consumers to overestimate actual infla-tion or patterns in forecast accuracy across socio-demographic groups have been widely observed across different surveys and countries (Jonung,1981;Bryan and Venkatu,2001;Coibion and Gorod-nichenko,2015). Several papers have shown that inflation expectations are formed heterogeneously and document that these heterogeneous expectations have implications for consumption and saving decisions (Bachmann et al.,2015;Duca et al.,2018;Dra¨ger and Nghiem,2020).1

In this paper, we present new evidence regarding the relevance of opinions on expected future economic developments. Specifically, we show that even households with the same inflation expec-tations can have very different opinions about the appropriate level of inflation and interest rates, and thereby about the right stance of monetary policy. This heterogeneity has implications for the transmission channel of monetary policy. While in the economics profession opinions have so far been somewhat neglected as a source of heterogeneity, in the social psychology literature - specificly in attribution theory - it has been long established how people form opinions and how they justify them.Jones and Nisbett(1972) andTversky and Kahneman(1973) report findings that people tend to view their own behavior as reflecting the changing demands of their environment.2This provides some understanding how opinions could also matter for economic decisions. It would not be surprising to see that consumers in our survey 'act' on their opinions and actually make spending decisions based on their opinions.

We first detail the 'hidden heterogeneity' in expectations using the Bundesbank Online Pilot Survey on Consumer Expectations. Overall, the majority of consumers believe that expected infla-tion is too high and expected interest rates are too low. Remarkably, even consumers with inflation expectations that are well within the ECB's target inflation rate of close to, but under 2%, differ substantially in their opinions of whether this is an appropriate level of inflation. Specifically, for consumers with inflation expectations between 1.5% and 2%, about 49% believe that expected in-flation is appropriate, 46% think it should be lower and 5% think it should be higher. Strikingly, even among consumers who expect deflation in the next year, about 30% would still prefer lower inflation. Generally, a large share of German households believes that inflation is too high. We observe similar heterogeneity also for consumers' opinions regarding the stance of monetary policy, i.e., future interest rates.

We further document that these differences in attitudes result in some heterogeneity in house-holds' consumption and savings profiles, even for consumers who share similar inflation expectations.

This implies an additional channel of monetary policy transmission via the attitudes of households in addition to the effect of inflation expectations on spending via the real interest rate. We find that when households perceive higher real rates, they postpone part of their spending on durable goods. This effect is in line with the theory, namely the intertemporal substitution effect in the

1For a recent survey on the formation of inflation expectations and their effect on economic decisions seeCoibion et al.(2020).

2They also report that people think that the behavior of others is trait dominated.

consumption Euler equation. Interestingly, the negative effect of perceived rates is only significant for consumers with inflation expectations in line with the ECB target, i.e., between 1.5% and 2%. Furthermore, those who believe interest rates should be lower in the future, are de facto acting as if (nominal) interest rates - and thus real interest rates - are already lower, as they have sig-nificantly higher durable goods spending and also a higher negative elasticity with respect to real rates. Interestingly, the effect of attitudes is not only relevant for current spending decisions, but also affects future planned spending on durable goods in a way which is consistent with theory. Distinguishing further between homeowners and renters, we find opposing effects of preferring lower inflation on current durable goods spending: Homeowners report lower current spending when they think inflation should be lower (in line with an Euler equation), while renters report higher durable goods spending.

Our paper relates to the literature explaining the heterogeneity of expectations across socio-demographic groups. Earlier contributions byJonung(1981),Bryan and Venkatu(2001) andPfajfar and Santoro(2009) demonstrate higher levels of both perceived and expected inflation for women, low education and low income groups, with a u-shaped effect of age where young and old respon-dents have higher expectations than middle age respondents. This pattern is highly prevalent in many different surveys across both different countries and time spans. More recent approaches byD'Acunto et al.(2019) andD'Acunto et al.(2019) demonstrate that the gender differences in infla-tion expectations can be traced to differences in daily grocery shopping experiences (as hypothesized inJonung,1981) and that they spill over into gender differences in expectations on other macroe-conomic variables. Moreover,Ehrmann et al.(2017) demonstrate that consumers' attitudes like optimism or pessimism regarding the economic outlook influence also the level of inflation expec-tations, whileD'Acunto et al.(2019) show that cognitive abilities play an important role. Finally, personal inflation experience can explain some of the differences in inflation expectations across age cohorts (Malmendier and Nagel,2016) and across different political systems, e.g., the Western part of Germany and the former German Democratic Republic (GDR) in the East of Germany before 1989 (Goldfayn-Frank and Wohlfahrt,2019).

Our paper is related also to a growing literature evaluating the link between survey inflation expectations and household spending decisions. Assuming consumers are following an Euler equa-tion, one would expect a positive effect from higher inflation expectations on current spending via its effect on the real rate, which could become particularly important when nominal interest rates are at the zero lower bound. WhileBachmann et al.(2015) andBurke and Ozdagli(2013) find little evidence of a significant link between inflation expectations and consumers' reported readiness to spend (or actual spending) on durables in the US,Crump et al.(2015) report a positive relation be-tween consumption growth and inflation expectations of US consumers in the Survey of Consumer Expectations (SCE) conducted at the New York Fed. Other studies on European and Japanese households find significantly positive links between household inflation expectations and (intended or actual) spending on both durables and non-durables (Ichiue and Nishiguchi,2015;D'Acunto

et al.,2016;Duca et al.,2018;Vellekoop and Wiederholt,2018;Dra¨ger and Nghiem,2020).

The remainder of the paper is organized as follows: Section 2 explains the data we use, while Section 3 discusses our results. Section 4 concludes.

2 Data

Our research question is evaluated using a new survey dataset coming from the Bundesbank Online Pilot Survey on Consumer Expectations, which was fielded on a representative sample of German households in three waves from April 2019 to June 2019. Overall, the dataset includes 6653 ob-servations, with 2009 participants in the first wave, 2052 in the second wave and 2592 in the third wave. In addition, the survey includes a panel component, as about 500 respondents participated in all three waves, 500 in wave 1 and 2, 500 in wave 2 and 3 and 500 in wave 1 and 3. For our analysis, we use mainly the first and second wave of the dataset and thus have about 1000 participants with responses in both waves.

The Bundesbank Online Pilot Survey on Consumer Expectations core questionnaire asks about consumers' macroeconomic expectations, housing market expectations and housing choices, current and planned spending and saving choices, as well as a large range of socio-demographic character-istics. We add the following questions to the core questionnaire. First, after the question on point estimates for inflation 12 months ahead, we ask about opinions on the expected level of inflation (included in the first wave):

1. Do you think the average level of inflation you expect for the next 12 months will be more or less appropriate, or do you think a higher or lower inflation rate would be better?

  • (a) Higher inflation than expected would be better (d infl highbetter)

  • (b) Inflation will be more or less appropriate (d infl reason)

  • (c) Lower inflation than expected would be better (d infl lowbetter)

Similarly, we ask about opinions on the expected level of nominal interest rates after the question on point estimates for expected saving rates in the next 12 months (included in the second wave):

2. Do you think the average level of interest rates you expect for the next 12 months will be more or less appropriate, or do you think a higher or lower interest rate would be better?

  • (a) Higher interest rate than expected would be better (d int highbetter)

  • (b) The interest rate will be more or less appropriate (d int reason)

  • (c) Lower interest rate than expected would be better (d int lowbetter)

In our analysis, we further control for quantitative point forecasts for the next 12 months regard-ing consumer price inflation,πe, the average savings rate,iesavingsand the average mortgage rate,imeortgage. In order to avoid an effect from extreme outliers, inflation expectations are truncated in the range between -5% and +25% and interest rate expectations are truncated to be below or equal to 25%.

Disclaimer

Board of Governors of the Federal Reserve System published this content on 10 July 2020 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 10 July 2020 14:15:01 UTC

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