This project aims to measure price and wage inflation expectations by modelling agents as being able to choose between different expectation rules based on their past performance. The study will be conducted by a group of two nuclear researchers (who specialize in macroeconomics and econometrics) and several consultants with positions in leading monetary policy institutions (who will aid with feedback and in the dissemination of the results).

The project aims to advance our understanding of price and wage inflation expectations.

 Expectations can be difficult to measure. Perhaps the most obvious way to do so would be by conducting a survey. However, answers to surveys can be sensitive to how the question is phrased and participants may not necessarily be truthful or fully understand what determines their choices. Such caveats and the importance of expectations measurement make it relevant that the information from surveys be complemented with alternative methods. The decisions of households and firms depend on their beliefs of what will happen in the future. Therefore, it is possible to deduce agent expectations from observed economic outcomes. One way to do so in the case of inflation expectations is through the Phillips curve which establishes a link between current inflation, the level of real economic activity and expected future inflation.

In this project, we combine a Phillips curve model (applied to price inflation and wage growth) with an evolutionary learning mechanism in which agents choose between different expectation rules (backward or forward-looking) based on their recent forecast ability. This will enable us to infer how inflation expectations have evolved over time by agents switching between backward and forward-looking rules.

We will apply, for the first time, the evolutionary learning mechanism developed by Brock and Hommes to wage inflation expectations and to price inflation expectations for other countries besides the US and UK. We will then extend the study of the feedback loop between price inflation and wage inflation using expectations rather than just the observed realized values of those variables. We will also study, for the first time, how movements in the adoption of different expectation rules (these are also obtained from the evolutionary learning mechanism developed by Brock and Hommes) by agents influence the volatility of price inflation (which affects the volatility of a country’s bond yields). This would enable us to learn how much of cross-country differences in the adoption of different expectation rules by agents can explain cross-country differences in inflation volatility and bond volatility.

The main target groups of this task are academic researchers in economics. Due to the importance of expectations to macroeconomic analysis and policy, leading economists “highlight the need for using alternative frameworks (…) in describing how expectations are formed” (see Coibion et al., 2018) and call on future research “to provide a better benchmark model of expectations” (see Mankiw and Reis, 2018).

 IDEAS, the largest bibliographic database dedicated to Economics, lists over 90 thousand works on inflation and more than 100 thousand on wages.

 A project on price inflation and wage growth expectations has potential for significant academic impact.

Aside from academic researchers, the main target groups of this task are monetary policy makers from all over the world. We will produce estimates of expectations for price inflation and wage growth for most countries in America and Europe. Moreover, we will also make available computer codes so that users from other countries can apply them.

The project has a high potential economic impact. Monetary policy has a strong effect on both the aggregate economy and financial markets. Central banks determine monetary policy and have as main goal having low inflation. The consensus today is that managing expectations is the most important component in controlling inflation (as stated by M. Woodford in his famous 2001 speech at Jackson Hole: “successful monetary policy is not so much a matter of effective control of overnight interest rates” but that “of affecting… the evolution of market expectations”). Therefore, monetary policy makers are a clear target group for the project´s results.

 We will also make use of the inflation expectations estimates to better understand inflation volatility and bond yields volatility, which is relevant to the management of public finances and assess financial stability. Fiscal policy makers and financial regulators may also benefit from the project´s research.

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With the objective to increase the research activity directed towards the achievement of the United Nations 2030 Sustainable Development Goals, the possibility of associating scientific projects with the Sustainable Development Goals is now available in Ciência_Iscte. These are the Sustainable Development Goals identified for this project. For more detailed information on the Sustainable Development Goals, click here.