The role of forward‐ and backward‐looking information for inflation expectations formation

• Date: 01 December 2019
• Author: Paul Hubert,Harun Mirza
• Published date: 01 December 2019
• DOI: http://doi.org/10.1002/for.2596

Received: 14 November 2018 Accepted: 12 March 2019

DOI: 10.1002/for.2596

RESEARCH ARTICLE

The role of forward- and backward-looking information for

inflation expectations formation

Paul Hubert1Harun Mirza2

1Sciences Po–OFCE, Paris, France

2European Central Bank, Frankfurt,

Germany

Correspondence

Paul Hubert, Sciences Po–OFCE, 10 place

de Catalogne, 75014 Paris, France.

Email: paul.hubert@sciencespo.fr

Funding information

European Union Seventh Framework

Programme, Grant/AwardNumber:

320278

Abstract

Assuming that private forecasters learn inflation dynamics to form their infla-

tion expectations and that they believe a hybrid New Keynesian Phillips curve

(NKPC) to capture the true data-generating process of inflation, we aim at

establishing the role of backward- and forward-looking information in the

inflation expectation formation process. We find that longer term expectations

are crucial in shaping shorter horizon expectations. While the influence of

backward-looking information seems to diminish over time, we do not find evi-

dence of a structural break in the expectation formation process of professional

forecasters. Our results further suggest that the weight put on longer term expec-

tations does not solely reflect a mean-reverting process to trend inflation. Rather,

it might also capture beliefs about the central bank's long-run inflation target

and its credibility to achieve inflation stabilization.

KEYWORDS

inflation, new keynesian phillips curve, survey expectations

1INTRODUCTION

Private expectations regarding future economic develop-

ments influence current decisions about wages, savings

and investments, and concurrently, policy decisions. In

recent years there has been an increasing interest in

explaining the private inflation expectations formation

process by departing from the full information rational

expectations hypothesis.1Another strand of literature has

focused on inflation dynamics and the role of private

1Within this literature, Mankiw and Reis (2002) propose a

sticky-information model, while Sims (2003), as well as Moscarini (2004)

or Mackowiak and Wiederholt (2009) focus on partial and noisy infor-

mation models. In both types of model, a fraction of the information

set used by private agents is backward looking—that is, based on past

information. Carroll (2003), Mankiw, Reis, and Wolfers (2003), Pesaran

and Weale (2006), Branch (2007), Nunes (2009), Andrade and Le Bihan

(2013), Coibion (2010), and Coibion and Gorodnichenko (2012, 2015a)

provide empirical evidence based on survey data to characterize and

distinguish these types of models.

expectations in estimating New Keynesian Phillips curves

(NKPC).2

The objective of this paper is to investigate inflation

expectation dynamics, not inflation dynamics. Webuild on

the result that the NKPC is a robust representation of how

inflation evolves. By bridging these two strands of litera-

ture, this paper aims to document the role of backward-

and forward-looking information in inflation expectation

dynamics and investigates the role of longer term private

inflation expectations in determining shorter term infla-

tion expectations. Assuming that professional forecasters

learn the dynamics of inflation to form their inflation

expectations and that they believe the reduced-form hybrid

2Roberts (1995, 1997), Galí and Gertler (1999), Rudd and Whelan (2005),

Nunes (2010), and Adam and Padula (2011, among others, assess the rel-

ative weights of forward- and backward-lookingcomponents of inflation.

The latter mayplay a role due to a share of “backward-looking” firms that

do not reoptimize their prices but set them according to a rule of thumb

(see, e.g., Steinsson, 2003) or index them to lagged inflation as in Galíand

Gertler (1999) or Christiano, Eichenbaum, and Evans (2005).

Journal of Forecasting. 2019;38:733–748. wileyonlinelibrary.com/journal/for © 2019 John Wiley & Sons, Ltd. 733

HUBERT AND MIRZA

NKPC captures the true data-generating process of infla-

tion dynamics, our contribution to the literature is to

propose an NKPC-based inflation expectations formation

equation. We then assess whether and by how much pro-

fessional forecasters' inflation expectations are driven by

forward-looking information (i.e., further-ahead expecta-

tions) or backward-looking information (i.e., past realized

or perceived inflation).

Three papers have opened this line of research. Lanne,

Luoma, and Luoto (2009) find that inflation expectations

are consistent with a sticky-information model where a

proportion of households base their expectations on past

inflation. Pfajfar and Santoro (2010) show that the dis-

tribution of professional forecasts might be explained by

three different expectation formation processes: a static or

highly autoregressive process, a nearly rational approach,

and adaptive learning and sticky information models.

Cornea-Madeira, Hommes, and Massaro (2017) find time

variation and heterogeneity in the type of expectations for-

mation with evolutionary switching between backward-

and forward-looking behavior.

Estimating these forward- and backward-looking

parameters matters for understanding how private expec-

tations are formed and how policymakers can anchor

them. Optimal monetary policy is determined by the

degree of price stickiness (see, e.g., Erceg, Henderson, &

Levin, 2000; Steinsson, 2003) and by the expectations for-

mation process—that is, whether professional forecasters

use up-to-date information about the state of the econ-

omy or continue using their previous plans and set prices

based on outdated information (see, e.g., Ball, Mankiw,

& Reis, 2005; Reis, 2009). Therefore, the real effects of

monetary policy and policy recommendations depend on

the speed of price adjustments, which in turn depend on

the (in)completeness of information and/or the degree of

backward- and forward-lookingness of price setters and

inflation forecasts.

We estimate our NKPC-based inflation expectations for-

mation equation on US data, for which survey expectations

of the gross domestic product (GDP) deflator from the

Survey of Professional Forecasters (SPF) are fixed-horizon

forecasts and available on a long time span—that is, from

1968:Q4. We test the robustness of our results using var-

ious variables for marginal costs, including a constructed

measure of the output gap. Finally,we also assess whether

relative weights have varied across time, differ with the

forecasting horizons, and whether longer term expecta-

tions could be seen as a proxy for trend inflation.

We provide original evidence that longer term inflation

expectations are crucial in determining shorter horizon

inflation expectations.3First, professional forecasters put

relatively more weight on forward-looking information

whereas the weight put on past information is significant

but quite small. Second, we find that the estimated param-

eter of forward-looking information tends to increase over

time, while there is no structural break. Though still sig-

nificant, the influence of backward-looking information

seems to diminish over time. Wealso find that these results

are stable when the forecasting horizon varies or when

we consider further-ahead horizons for forward-looking

information. Our results further suggest that longer-term

expectations should not be seen as a proxy for trend infla-

tion. Third, the coefficients are similar to those found in

the literature estimating the actual NKPC, which suggests

that professional forecasters may use this relationship to

form their own inflation expectations.4

These results are related to Ang, Bekaert, and Wei(2007)

and Cecchetti, Hooper,Kasman, Schoenholtz, and Watson

(2007). They provide evidence that survey expectations

have a good forecasting performance that stems from sur-

vey respondents' ability to anticipate structural change.

One reason why professional forecastersuse further-ahead

expectations—information at horizons further ahead than

the forecasting horizon—to form their expectations could

thus be that further-ahead expectations might be seen as

a representation of the long-run beliefs about the central

bank inflation target and about the central bank credi-

bility to achieve inflation stabilization. The fact that the

weight on forward-looking (backward) information has an

upward (downward) dynamic echoes back to Coibion and

Gorodnichenko (2015b) and the “anchored expectations”

hypothesis of Bernanke (2010), that the credibility of the

Federal Reserve is such that neither high inflation nor

deflation is seen as a plausible outcome so actual infla-

tion, and short-run inflation expectations remain stable

through expectational effects. z The two main implications

of these results for policymakers are, first, that anchoring

medium- or long-term expectations enables anchoring

shorter term expectations and, second, that professional

forecasters' expectations still depend (in part) on past

information. Importantly, it appears that the expecta-

tion formation process is relatively stable over time.

Besides, the estimated parameters may serve for calibrat-

ing macroeconomic models in which private expectations

3This result is found to be robust to specification tests, to the exclusion

of the financial crisis and post-2007 data, to the use of real-time data, to

generalized method of moments (GMM) estimation, to various measures

of marginal costs, and to the inclusion of potentially relevant additional

variables.

4Mavroeidis, Plagborg-Moller, and Stock (2014) and Coibion, Gorod-

nichenko, and Kamdar (2018) survey empirical evidence on the actual

NKPC and find a vast set of results. Our estimated coefficients for the

NKPC-based equation are in the mode region of the distribution of all

point estimates they report.

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