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In this episode of Lehigh University’s College of Business ilLUminate podcast, we are speaking with Fabio Gómez-Rodríguez about why inflation expectations are important. Dr. Gómez-Rodríguez is an assistant professor in economics in Lehigh's College of Business. His research interests are time series econometrics, monetary and fiscal policy, and data science.

Gómez-Rodríguez spoke with Jack Croft, host of the ilLUminate podcast. Listen to the podcast here and subscribe and download Lehigh Business on Apple Podcasts or wherever you get your podcasts.

Below is an edited excerpt from that conversation. Read the complete podcast transcript [PDF]

Jack Croft: What is the role that inflation expectations play in the economy? Let's start with the definition of inflation expectations.

Gómez-Rodríguez: Inflation expectations, as the name says, is what we expect inflation to be. It turns out that even if we have followed what inflation has been, what's more important for our decisions—for example, to buy a car or buy a house—what really will matter is what do we expect to happen with inflation in the future? And that becomes inflation expectations.

So if you think, for example, that your money is going to lose weight in a very, very rapid way, then you will want to spend that money. And if many people think like you, a lot of people are going to spend money in whatever they want to buy. And eventually, that's going to make businesses say, "Well, I'm selling a lot. So I'm going to increase my prices to improve my revenue."

What happens is that whenever inflation expectations are on the rise or are high inflation expectations, inflation today turns out to increase. And the same thing happens in the other case, which would be if inflation expectations are controlled or even low for some reason, well, that makes us keep our money a little bit longer. And therefore, also, prices will not respond as fast, and that makes prices not to increase as quickly, and therefore inflation will be lower.

So the role of inflation expectations is that it works almost like a time machine. Whatever you think is going to happen, somehow ends up happening if the collective, the whole economy together, thinks the same way. So as long as inflation expectations are controlled, we can control the inflation. If inflation expectations are high, inflation is going to go up. If inflation expectations are low, then the inflation is going to go down.

That's why the Federal Reserve, or any central bank for that matter, will pay a lot of attention to what's happening with inflation expectations, trying to keep it not too high, not too low. Usually, they try to make their inflation target—which for the Fed is 2%. For other banks, it could be some other number. They try to keep inflation expectations as close as possible to whatever inflation target they have.

Croft: I think most of us are used to reading about expected inflation rates for the coming months or year or hearing about them on the news. I don't know that a lot of us have given much thought to where exactly do those expectations come from? Who is setting those expectations?

Gómez-Rodríguez: In general, we can separate two types of ways in which you can calculate or obtain inflation expectations. One of them is-- I call it a little bit more sophisticated, which is market-based inflation expectations. Market-based inflation expectations are inflation expectations that can be inferred or derived from the difference in the price of financial instruments that are protected against inflation versus those that are not protected. …

It turns out that there are mathematical methods and economic models, econometric models as well, that will measure what the implicit inflation expectations of their market are based on the difference in prices of these two alternatives—some sort of instruments or products that are protected against inflation, versus some of them that are not protected against inflation. And the difference we say is because of inflation expectations. And then we use that as a measure of what inflation expectations are.

There's an important thing here, and it is basically that not everyone will be able or even participate in these markets. So what's going to happen is that inflation expectations that are measured this way are not necessarily the expectations of the whole population, but it's more inflation expectations of a very selected group of people. And what happens is that everyone is part of the economy, not just people who invest their money with this type of alternatives.

So if you want to try to have a better understanding of inflation expectations for the whole economy, you have to rely on the second type of inflation expectation measurements, which is through surveys. For example, the University of Michigan has a very well-known survey of consumers. They ask many questions about different things. And one of the questions is, "What do you think inflation is-- or how do you think prices are going to change over the next 12 months?" And then they also ask, "What do you think prices are going-- or how do you think prices are going to change from 5 to 10 years ahead?"

Because it turns out that inflation expectations is not necessarily just a matter of what you expect in the near future; also what you think is going to happen in the long run matters. So these two types of questions are answered in the survey. And this obviously, because it's much easier to just ask people what their opinion is on inflation expectations, it also covers a much bigger portion of the population. And therefore, maybe in that sense, a little bit more reliable to try to capture the opinion of all the economy and not just a selected group of people.

Croft: I wonder, and this gets into a bit more about your research, but we always hear the mean or median averages for expected inflation. So let's say the latest information comes out, and they're saying in a survey that it's 3%, and it's been 3% in the previous two times. Does that mean there's been no change in the inflation rate?

Gómez-Rodríguez: No. … One of the things that happened is that whenever we started thinking about the fact that inflation expectations are important for the economy, at that moment, maybe we didn't have computers that are as fast as the ones that we have today or as much memory as they have today. And even some of the statistical methods that we had at that point were not sophisticated enough to deal with the fact that we all have different inflation expectations.

So at that moment, the easiest thing to do was, well, I'm going to ask, I don't know, 300 people whether inflation expectations are, and I'm just going to take the average. And that's going to be the inflation expectation. 3%, as you said, for example. And then it turns out that it is possible that in the last three months or three last periods that we observe inflation expectations, the average keeps giving me 3%. So it might seem like inflation expectations are not changing. But what might have changed is what's called the distribution of inflation expectations.

We don't know if that average of 3% is everyone saying it's 3%, or maybe if some of them say-- half of them say 2% and the other half say 4%. That's also an average of 3%. Or what if some of them think inflation expectations-- or their inflation expectations is 10% and some of them say that their inflation expectation is 2% and then some say 3%, and maybe when we put all of them together in an average, it becomes 3% again.

So what I'm trying to say is that the fact that we observe an average of 3% does not mean that everyone thinks it is 3%. And that's what my research does. My most recent paper is about how inflation expectations being treated as a whole set of different inflation expectations can give us a new light on how expected inflation influences inflation itself. For example, one of the things that I measured there is, first of all, how decisions of the government, like the Fed changing the interest rates or maybe the government deciding to spend money building a new highway or something like that, or even taxes, how this kind of decisions by the government changes the distribution of inflation expectations. …

Let me summarize a little bit what I'm trying to say. The Fed changes interest rates to try to fight inflation. They increase interest rates to get back to the inflation that they want to have. There are many ways in which the increase in interest rates is going to affect the economy. And I'm arguing that one of these channels is inflation expectations.

Tags: inflation
Fabio Gómez-Rodríguez

Fabio Gómez-Rodríguez

Fabio Gómez-Rodríguez, Ph.D., is an assistant professor in the Department of Economics at Lehigh University College of Business.