Inflation Expectations and Learning about Monetary Policy

Various measures indicate that inflation expectations evolve sluggishly relative to actual inflation. In addition, they often fail conventional tests of unbiasedness. These observations are sometimes interpreted as evidence against rational expectations.

The authors embed, within a standard monetary dynamic stochastic general-equilibrium model, an information friction and a learning mechanism regarding the interest-rate-targeting rule that monetary policy authorities follow. The learning mechanism enables optimizing economic agents to distinguish between transitory shocks to the policy rule and occasional shifts in the inflation target of monetary policy authorities.

The model's simulated data are consistent with the empirical evidence. When the information friction is activated, simulated inflation expectations fail conventional unbiasedness tests much more frequently than in the complete-information case when this friction is shut down. These results suggest that an important size distortion may occur when conventional tests of unbiasedness are applied to relatively small samples dominated by a few significant shifts in monetary policy and sluggish learning about those shifts.

Also published as:

Are inflation expectations rational?
Journal of Monetary Economics (0304-3932)
March 2008. Vol. 55, Iss. 2, pp. 406-22