Tuesday, September 27, 2016

Why are Long-Run Inflation Expectations Falling?

Randal Verbrugge and I have just published a Federal Reserve Bank of Cleveland Economic Commentary called "Digging into the Downward Trend in Consumer Inflation Expectations." The piece focuses on long-run inflation expectations--expectations for the next 5 to 10 years-- from the Michigan Survey of Consumers. These expectations have been trending downward since the summer of 2014, around the same time as oil and gas prices started to decline.  It might seem natural to conclude that falling gas prices are responsible for the decline in long-run inflation expectations. But we suggest that this may not be the whole story.

First of all, gas prices have exhibited two upward surges since 2014, neither of which was associated with a rise in long-run inflation expectations. Second, the correlation between gas prices and inflation expectations (a relationship I explore in much more detail in this working paper) appears too weak to explain the size of the decline. So what else could be going on?

If you look at the histogram in Figure 2, below, you can see the distribution of inflation forecasts that consumers give in three different time periods: an early period, the first half of 2014, and the past year. The shaded gray bars correspond to the early period, the red bars to 2014, and the blue bars to the most recent period. Notice that there is some degree of "response heaping" at multiples of 5%. In another paper, I use this response heaping to help quantify consumers' uncertainty about long-run inflation. The idea is that people who are more uncertain about inflation, or have a less precise estimate of what it should be, tend to report a round number-- this is a well-documented tendency in how people communicate imprecision.
The response heaping has declined over time, corresponding to a fall in my consumer inflation uncertainty index for the longer horizon. As we detail in the Commentary, this fall in uncertainty helps explain the decline in the measured median inflation forecast. This is a remnant of the fact that common round forecasts, 5% and 10%, are higher than common non-round forecasts.

There is also a notable change in the distribution of non-round forecasts over time. The biggest change is that 1% forecasts for long-run inflation are much more common than previously (see how the blue bar is higher than the red and gray bars for 1% inflation).  I think this is an important sign that some consumers (probably those that are more informed about the economy and inflation) are noticing that inflation has been quite low for an extended period, and are starting to incorporate low inflation into their long-run expectations. More consumers expect 1% inflation than 2%.


  1. [Obligatory "may be a dumb question" disclamer.]
    How much of the decline in inflation expectations do you think could be related to survey population changes in that, as time passes, the adult-lifetime average level of inflation seen be the respondents declines.

    1. Hi! This is not a dumb question-- in fact, the authors who tried to address it got a publication in QJE! Here's an ungated version: http://eml.berkeley.edu/~ulrike/Papers/InflExp_44.pdf

  2. Quite simple. The higher the proportion of savings deposits to transaction deposits, the lower money velocity. Therefore, the lower aggregate demand (volume X's velocity). This is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, that there's no difference between money and liquid assets. Secular strangulation is simply savings bottled up in the payment's system. It didn't begin in 1980, it began in 1957. It was simply hidden by commercial bank deposit innovation - which plateaued in 1981 with the advent of widespread ATS, NOW, and MMDA accounts. It is exacerbated by remunerating IBDDs.

  3. AD = M*Vt - not N-gDp. Vt, not Vi (a contrived figure), has decelerated since the 1981. This was predicted in May 1980. Figures for Vt were discontinued in Sept. 1996. This is how it previously worked:


  4. And we knew this already: In 1931 a commission was established on Member Bank Reserve Requirements. The commission completed their recommendations after a 7 year inquiry on Feb. 5, 1938. The study was entitled "Member Bank Reserve Requirements -- Analysis of Committee Proposal" It's 2nd proposal: "Requirements against debits to deposits"


    Monetary policy objectives should be formulated in terms of desired rates-of-change, roc's, in monetary flows, M*Vt (volume X’s velocity), relative to roc's in R-gDp. Roc's in N-gDp (though "raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in N-gDp"), can serve as a proxy figure for roc's in all transactions, P*T, in Professor Irving Fisher's truistic: "equation of exchange". Roc's in R-gDp have to be used, of course, as a policy standard.

    After a 45 year hiatus, this research paper was "declassified" on March 23, 1983. By the time this paper was "declassified", Nobel Laureate Dr. Milton Friedman had declared RRs to be a "tax" [sic].

  5. "Neutrality of money is the idea that a change in the stock of money affects only *nominal* variables in the economy such as Prices, Wages, and Exchange rates, with no effect on *real* variables, like Employment, Real GDP, and Real consumption." - Wikipedia
    Money flows (volume Xs velocity), short and long distributive lags, have turned positive. Thus (contrary to BuB, as evidenced by his FAVAR 2002 paper), since money flows are robust (not neutral), R-gDp should increase in the 3rd qtr.

    parse; dt, real-output, inflation:

    01/1/2017,,,,, 0.13 ,,,,, 0.19
    02/1/2017,,,,, 0.08 ,,,,, 0.16
    03/1/2017,,,,, 0.06 ,,,,, 0.13
    04/1/2017,,,,, 0.08 ,,,,, 0.18
    05/1/2017,,,,, 0.09 ,,,,, 0.23
    06/1/2017,,,,, 0.08 ,,,,, 0.21 commodities & rates bottom
    07/1/2017,,,,, 0.13 ,,,,, 0.22
    08/1/2017,,,,, 0.11 ,,,,, 0.26
    09/1/2017,,,,, 0.10 ,,,,, 0.27 commodities & rates top
    10/1/2017,,,,, 0.06 ,,,,, 0.27
    11/1/2017,,,,, 0.08 ,,,,, 0.25
    12/1/2017,,,,, 0.11 ,,,,, 0.17

    - Michel de Nostredame (cracked the macro-economic code in July 1979)


Comments appreciated!