Tuesday, January 22, 2013

Japan and the Formation of Inflation Expectations

With the Bank of Japan's adoption of a 2% inflation target making headline news, it seems like a good time to discuss some recent research on the psychology of inflation expecations by Berkeley Professor Ulrike Malmendier, who was recently awarded the 2013 Fischer Black Prize from the American Finance Association. This biennial prize honors the top finance scholar under the age of 40 years old. Malmendier works in the intersection between finance and behavioral economics and is known for her incredible creativity.

Here is the abstract of Malmendier's paper with Steven Nagel titled "Learning from Inflation Experiences":
How do individuals form expectations about future inflation? We propose that past inflation experiences are an important determinant absent from existing models. Individuals overweigh inflation rates experienced during their life-times so far, relative to other historical data on inflation. Differently from adaptive-learning models, experience-based learning implies that young individuals place more weight on recently experienced inflation than older individuals since recent experiences make up a larger part of their life-times so far. Averaged across cohorts, expectations resemble those obtained from constant-gain learning algorithms common in macroeconomics, but the speed of learning differs between cohorts.
Using 54 years of microdata on inflation expectations from the Reuters/Michigan Survey of Consumers, we show that differences in life-time experiences strongly predict differences in subjective inflation expectations. As implied by the model, young individuals place more weight on recently experienced inflation than older individuals. We find substantial disagreement between young and old individuals about future inflation rates in periods of high surprise inflation, such as the 1970s. The experience effect also helps to predict the time-series of forecast errors in the Reuters/Michigan survey and the Survey of Professional Forecasters, as well as the excess returns on nominal long-term bonds.
Malmendier and Nagel's paper over a time period covering several monetary policy regimes, which differ markedly from that of Japan. But a related paper by David Blanchflower and Conall Mac Coille focuses on the UK, which practices inflation targeting.  "The Formation of Inflation Expectations: an Empirical Analysis for the UK" (2009) includes a summary of why inflation expectations matter for monetary policy, and how this is relevant to inflation targeting: 
In the neo-Keynesian model (see, for example, Clarida et al. 2000), sticky prices result in forward looking behaviour; inflation today is a function of expected future inflation as well as the pressure of demand, captured in an output gap term. Thus, expectations are deemed to be an important link in the monetary transmission mechanism. Monetary policy can be more successful when long-term inflation expectations are well anchored. Hence, many studies have focused on the question of how to assess the response of inflation expectations to macroeconomic shocks, and whether this is likely to be lower in inflation targeting regimes. 
Blanchflower and Mac Coille also summarize three paths through which inflation expectations matter:
Wages are set on an infrequent basis, thus wage setters have to form a view on future inflation.  If inflation is expected to be persistently higher in the future, employees may seek higher nominal wages in order to maintain their purchasing power.  This in turn could lead to upward pressure on companies’ output prices, and hence higher consumer prices.  Additionally, if companies expect general inflation to be higher in the future, they may be more inclined to raise prices, believing that they can do so without suffering a drop in demand for their output.  A third path by which inflation expectations could potentially impact inflation is through their influence on consumption and investment decisions.  For a given path of nominal market interest rates, if households and companies expect higher inflation, this implies lower expected real interest rates, making spending more attractive relative to saving. 
In Japan, the third path may be most important. The higher inflation target is intended to lower real interest rates and boost consumption and investment. But there is a fourth reason, not listed by Blanchflower and Mac Coille, of particular relevance to Japan. Foreigners' expectations of future inflation affect the value of the currency. the Japanese Ministry of Finance recently revealed a 222.4 billion yen ($2.5 billion) current account deficit-- a measure of how much imports exceed exports. When people expect Japanese inflation to be higher in the future, the yen gets less valuable now, because it won't be able to buy as much stuff later; the yen weakens. But in this case, weakness is not necessarily bad. A weaker yen means that Japanese people will find it more expensive to import stuff, so they will import less. Likewise, people outside of Japan will find it cheaper to buy Japanese stuff, so Japan will export more. This helps shrink the current account deficit. And depending on the sizes of the income and substitution effects, Japanese consumers may buy more Japanese products.

Under inflation targeting in the UK, even though inflation expectations are reasonably well anchored, and median expectations are around the inflation target, there is substantial heterogeneity across agents in their inflation expectations. Malmendier and Nagel's paper provides a behavioral theory to explain part of this heterogeneity based on agents' heterogeneous past experiences of inflation. Heterogeneous inflation expectations have the potential to affect the workings of all the paths through which inflation expectations matter. We need to understand not only how Japan's inflation target will influence median inflation expectations, but also how it will affect expectations of price setters, wage setters, borrowers, savers, exporters, trade partners, etc. More than likely, these groups differ significantly in their demographics, have had different experiences, and thus form different expectations of inflation. (For reference, the graph below displays Japanese inflation, interest rates, real GDP per capita growth rate, and M2 growth rate. Japan has not seen 2% inflation since 1997.) Extensions of Malmendier's research to other countries and monetary regimes will be very useful in understanding the effects of monetary policy.


  1. How would you argue against someone like Scott Sumner, a monetarist, who argues that "higher real interest rates increase inflation" not "lower real interest rates."

    He writes the themoneyillusion.com blog..

    Here is his post on the above statement: http://www.themoneyillusion.com/?p=18780

  2. Hi Econ Wizard, thanks for the link. I'm not sure I need to argue against Sumner. Japan's nominal interest rate is already at the zero lower bound, and they are not targeting it. Japan's plan is large-scale asset purchases, which will increase the money supply. (Sumner is talking about the case when the money supply is held constant.) If the bank is credible, and people don't expect the purchases to be reversed as soon as the economy starts to recover, then inflation and expected inflation can be 2%.
    Sumner writes in the article that the overall effect of tight monetary policy is deflationary. So I think he would agree that Japan's easy monetary policy would be inflationary, which is the goal.

  3. Agreed. Just very interesting nonetheless. I love reading monetary policy from a monetarist and Keynesian. Very different ideas at to how interpret situations of liquidity-trapped economies.

    As for Japan, I feel the aging population is an issue in terms of monetary policy. Consumers aren't as able and nimble to spend a rapidly depreciating yen, therefore I feel that the inflation target may be subdued in the medium term because of depressed demand.

  4. Carola,

    First of all, it's great to see other econ grad students blogging!

    You mention that "The higher inflation target is intended to lower real interest rates and boost consumption and investment." It may be worthwhile to consider how credible the inflation target is in order to determine the magnitude of this effect. Japan has held a 1% inflation target for many years but frequently been unable to achieve that level. Furthermore, the BoJ doesn't expect to reach the 2% target for a few years, which may dampen any current impact.

    Separately, you note that a weaker yen "helps shrink the current account deficit." Until very recently Japan had been running a persistent and sizable current account surplus for over 20 years. This had occurred in spite of consistent yen appreciation. It therefore appears factors other than the exchange rate play a major role in determining the current account balance.

    Lastly, in the comments you suggest that Japan is not targeting the nominal interest rate. I believe the BoJ pays a slightly positive IOR, so in that sense they are targeting a rate that is marginally above zero (which would otherwise be the rate given the amount of excess reserves).

    All that being said, this is very interesting research, especially the differences among demographics. Do you have any intentions of personally furthering that line of research?

  5. I agree with Matthew Cruz. Japanese any older than about 55 (i.e. the fastest growing sector of the population) are generally internet illiterate for a start (fax is still big in Japan), which in the 21st century is bound to stifle consumption big time.

  6. Hi Joshua, thanks for your comments. I'm a fan of your blog! Yes, I'm considering working on research related to that topic. I'm currently working on studying how macroeconomic uncertainty is generated and how it affects the economy.

    David and Matthew, does Internet literacy increase consumption? Are you thinking the velocity of money is different for older people? That could be interesting...

  7. Good post, Carola!

    While I'm not a blogger myself, I regularly follow the econoblogosphere! (I found you via Noah Smith's blog.)

    It's good to see a new face on the econoblogosphere - and I don't mean to be sexist, but a female economist at that! (Call me ignorant, but I haven't found many female economists who blog.)

    Would you mind if I asked you the following questions?

    1.) Would you be interested in decision theory or experimental economics?

    2.) What is your opinion of Subjective Expected Utility?

    3.) Would it be possible for me to e-mail you? I'd like to send you a few papers.

  8. Blue Aurora, thanks. I am interested in decision theory, and while my own research is not directly in decision theory, I do study expectations formation in the macroeconomy and decisionmaking under uncertainty. I don't have a well-informed opinion of SEU at this point. You can email me at carolaconces [at] gmail [dot] com.

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