Households’ inflation expectations have increased sharply. How does this affect the economy? Two recent studies, which we summarize below, suggest that following a shock to inflation expectations, the economy is more likely to experience “stagflation”—a situation where inflation is elevated while economic growth slows down. These studies support the current FRB-US baseline (here), which predicts a slowdown in economic growth along with slightly higher and lasting inflation.
Paper #1: Ascari et al. (2024)
“Endogenous Uncertainty and the Macroeconomic Impact of Shocks to Inflation Expectations” (published on the JME) by Guido Ascari et al. (2024) argues that an increase in inflation expectations leads to higher inflation and lower output (“stagflation”-type), resembling a negative supply shock. The authors emphasize the role of endogenous uncertainty, which amplifies these effects.
What the paper does and main results
The authors construct a DSGE model featuring endogenous firm entry and exit, sticky wages, and price adjustment costs. The model highlights how firms adjust their pricing behavior in response to inflation expectations. To distinguish inflation expectation shocks from standard supply shocks, the authors examine the response of output uncertainty and the dividend-to-price ratio. Inflation expectation shocks increase uncertainty and the dividend-price ratio, whereas supply shocks reduce them. Finally, the authors estimate a structural VAR using U.S. data from 1971 to 2019, identified using sign restrictions. In both cases -that is, the theoretical model and the data- shocks to inflation expectations raise uncertainty across financial and real economic indicators, triggering an output loss and an increase in consumer price inflation (see Figure 1).
Figure 1. VAR Impulse Response Functions (IRFs) to an increase in inflation expectations
Paper #2: Ascari et al. (2024)
“The Macroeconomic Effects of Inflation Expectations: The Distribution Matters” by Guido Ascari et al. (2024) argues that shocks to the mean and variance of inflation expectations are stagflationary, leading to higher inflation and lower output.
What the paper does and main results
Using a Bayesian VAR model, augmented with data from the Michigan Survey of Consumers, the authors explore how the distribution of inflation expectations affect macroeconomic variables. The empirical findings show that (i) expectations affect macroeconomic outcomes but not the other way around, (ii) considering the first and second moment of the inflation distribution leads to an underestimation of the effects on macro variables, (iii) mean and variance shocks are stagflationary (see Figure 2), as they increase inflation and reduce output (industrial production).
Figure 2. IRFs to a shock to the variance (dashed blue lines) and to the kurtosis (dashed-dotted red lines) of inflation expectations distribution.
Conclusion
We have discussed the implications for the Fed in our “Pre-March 2025 FOMC Meeting Package” (here). In a nutshell: uncertainty is too high right now, and both sides of the mandate are under stress. What happened with inflation expectations is important, as it can have a sizable “stagflationary” impact, as discussed above. We continue to think the FOMC is unlikely to commit strongly in either direction, at least at this round.