Central banks pay close attention to inflation expectations. In standard models, however, inflation expectations are tied down by the assumption of rational expectations and should be of little independent interest to policy makers. In this paper, the authors relax the assumption of rational expectations with perfect knowledge and reexamine the role of inflation expectations in the economy and in the conduct of monetary policy. Agents are assumed to have imperfect knowledge of the precise structure of the economy and the policymakers’ preferences. Expectations are governed by a perpetual learning technology. With learning, disturbances can give rise to endogenous inflation scares, that is, significant and persistent deviations of inflation expectations from those implied by rational expectations. The presence of learning increases the sensitivity of inflation expectations and the term structure of interest rates to economic shocks, in line with the empirical evidence. The authors also explore the role of private inflation expectations for the conduct of efficient monetary policy. Under rational expectations, inflation expectations equal a linear combination of macroeconomic variables and as such provide no additional information to the policy maker. In contrast, under learning, private inflation expectations follow a time-varying process and provide useful information for the conduct of monetary policy.
JEL classification: E52
Keywords: inflation forecasts, policy rules, rational expectations, learning
The authors would like to thank George Evans, Ben Friedman, Peter Ireland, Lars Svensson, and participants at presentations at the University of California, Berkeley, the Norges Bank, meetings of the Econometric Society, the American Economic Association, the Society for Computational Economics, and at the Federal Reserve Bank of Atlanta Conference on Learning, March 21-22, 2003, for useful comments and discussions on earlier drafts. This paper was presented at the Monetary Policy and Learning Conference sponsored by the Federal Reserve Bank of Atlanta in March 2003. The views expressed here are the authors’ and not necessarily those of management of the Federal Reserve Bank of San Francisco, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
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