The Formation of Consumer Inflation Expectations: New Evidence From Japan’s Deflation Experience
Using a new micro-level dataset we investigate the relationship between the inflation experience and inflation expectations of households in Japan. We focus on the period after 1995, when Japan began its era of deflation. Our key findings are fourfold. Firstly, we find that inflation expectations tend to increase with age. Secondly, we find that measured inflation rates of items purchased also increase with age. However, we find that age and inflation expectations continue to have a positive correlation even after controlling for the household-level rate of inflation. Further analysis suggests that the positive correlation between age and inflation expectations is driven to a significant degree by the correlation between cohort and inflation expectations, which we interpret to represent the effect of historical inflation experience on expectations of future inflation rates.
Since at least the time of Keynes (1936), economic agents’ expectations of future inflation rates have played a pivotal role in macroeconomics. Woodford (2003) describes the central importance of inflation expectations to modern macroeconomic models due to the intertemporal nature of economic problems, while Sargent (1982) and Blinder (2000) highlight the dependence of monetary policy on these expectations. However, despite the important role of inflation expectations, their formal inclusion in macroeconomic models is usually ad-hoc with little empirical justification.