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May 26, 2007

Why Not Just Ask?

I'm home at last from the Conference on Price Measurement for Monetary Policy that has absorbed my attention over the past couple of days, but I have one more post on the topic left in me, not least because the topic of the last several papers -- the measurement of inflation expectations gleaned from survey data -- is one in which I have a particular interest.  As far as I know, the review of the ECB Survey Professional Forecasters (SPF) (by authors from the European Central Bank too numerous to mention here) is the first large-scale overview of its kind, and thorough it is.  Among the copious information is this, which I found particularly interesting:

... average long-term expected inflation has remained quite stable since the beginning of the survey. On average, it stood at 1.88% with a standard deviation of ┬▒0.04 percentage point. The average long-term inflation expectation was 1.9% at the start of Stage III of EMU in 1999. It declined to 1.8% in 2000 and then shifted upwards to stand at 1.9% again at the end of 2002. Since then, it has remained broadly stable at below, but close to, 2%, confirming the stability of SPF long-term inflation expectations.

The picture, proving the point:


Contrast this with a fascinating observation from the National Bank of Belgium's Luc Aucremanne, Marianne Collin and Thomas Stragier, contrasting actual inflation with perceived inflation based on surveys of consumers:

While there is clearly no doubt about the accuracy of official inflation measures in the euro area during the recent period, there is plenty of anecdotic evidence that since 2002 consumers have tended to perceive that inflation is high, while in reality it was relatively low, albeit slightly above the quantified definition of price stability for the euro area. Apparently a perception gap has grown in the euro area since the euro cash changeover in January 2002.

The pictures are striking:


The kicker is that no such divergence in perceptions occurred in comparable European countries that did not adopt the euro:


I'm not sure what to make of that, other than that there is an awful lot we don't know about what consumers are telling us when they answer these survey questions -- an observation that is confirmed in a review of survey responses from the Czech Republic, Hungary, Poland, and Slovakia by Ryszard Kokoszczynski, Tomasz Lyziak, and Ewa Stanislawska (of the National Bank of Poland). 

Until we more clearly understand household responses to the questions we ask, it appears that surveys of professional forecasters represent the best available source for obtaining direct information about inflation expectations.  There is growing literature on how to get the most out of these surveys, and I'll close with a word of praise for the paper "What Can Four Decades of Probabilistic Inflation Forecasts Tell Us About Inflation Risks?" by the ECB's Juan Angel Garcia and Andres Manzanares.  As the title of the paper makes clear, the idea is to characterize, for example, whether survey respondents see the balance of inflation risks as weighted to the upside or downside.  The literature to which the Garcia-Manzanares paper belongs tends to the technical, but it is well worth a look if you have a stake in knowing which way the forecaster winds are blowing.

May 26, 2007 in Europe, Federal Reserve and Monetary Policy, Inflation | Permalink


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"While there is clearly no doubt about the accuracy of official inflation measures in the euro area during the recent period"

How nice...

Posted by: Laurent GUERBY | May 26, 2007 at 02:55 PM

I participated to the SPF from the start in 1999 (including commenting on the design) and stopped a couple years ago as I am now based 4 degrees north...

In my experience, the fact that you note, eg the stability of long term expectations simply reflects that forecasters are not well equipped to make forecasts 5 or 10 years out. Therefore most of us would reply in the 1.8-1.9 range to that particular question as a reflection of our understanding that the particulars of the ECB mandate made inflation control its overriding objective and that we thought that it had at its disposal the understanding of the inflationary process and the tools to make sure that it achieved this objective. Any deviation from these figures would reflect a severe loss of credibility of the ECB.

On the deviation between the public's perception (up) and the measured reality of inflation, many of us noted this early on. This reflected the fact that prices for those items that the public purchases at high frequency using coins and notes (the value of which they had some trouble assessing early on) rose steeply in the first few years. However, because these expenditures are but a small part of consumer's budgets, it did not affect notably overall prices. Other items purchased at low frequency (ex. cars, rents,insurance,clothes etc.) did not see such price movements.

Three points remain very interesting here in my view:

1. the fact that consumer's perceptions distort the weights of high frequency purchased items using hard cash compared to others (let us call in psychologists and economists for research). Politicians were quick to seize on this in some Euro member countries.

2. checks and plastic money do not impress consumer memories the way coins and notes do.

3. Even wrongly but actually held inflationary views could have important consequences in the wage-price negotiating area. It took the ECB a long time to acknowledge this risk. In other words, is it actual price movements or perceived price movements that matter for wage setting ?

Posted by: 4degreesnorth | May 31, 2007 at 05:52 AM

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