Contents. Abstract 4. Non-technical summary Introduction 7

Transcription

1 EUROPEAN CENTRAL BANK WORKING PAPER SERIES WORKING PAPER NO 163 THE RATIONALITY OF CONSUMERS INFLATION EXPECTATIONS: SURVEY-BASED EVIDENCE FOR THE EURO AREA BY M FORSELLS AND G KENNY Augus 2002

2 EUROPEAN CENTRAL BANK WORKING PAPER SERIES WORKING PAPER NO 163 THE RATIONALITY OF CONSUMERS INFLATION EXPECTATIONS: SURVEY-BASED EVIDENCE FOR THE EURO AREA BY M FORSELLS AND G KENNY * Augus 2002 * Th viws xprssd in his papr ar hos of h auhors and do no ncssarily rflc hos of h Europan Cnral Bank W would lik o hank an anonymous rfr, Gabril Fagan, Grard Korwg, Bina Landau, Juan Angl Garcia, Francsco Monglli, Digo Rodriguz Palnzula and ohr paricipans a an inrnal sminar in h ECB for hlpful commns and suggsions W also would lik o hank Hinz Chrisian Didn for hlp wih h uro ara survy daa Any rrors ar of cours h sol rsponsibiliy of h auhors

3 Europan Cnral Bank, 2002 Addrss Kaisrsrass 29 D Frankfur am Main Grmany Posal addrss Posfach D Frankfur am Main Grmany Tlphon Inrn hp://www cb in Fax Tlx cb d All righs rsrvd Rproducion for ducaional and non-commrcial purposs is prmid providd ha h sourc is acknowldgd Th viws xprssd in his papr ar hos of h auhors and do no ncssarily rflc hos of h Europan Cnral Bank ISSN

4 Conns Absrac 4 Non-chnical summary 5 1. Inroducion 7 2. Esimaing uro ara inflaion xpcaions from survy daa Th probabiliy approach o simaing inflaion xpcaions Rsuls for h uro ara Propris of uro ara inflaion xpcaions Long-run propris: Tsing for bias Dynamic propris: Th adjusmn of xpcaions Simpl ss of macroconomic fficincy Conclusions 25 Rfrncs 27 Annx 1: Tabls & chars 30 Annx 2: Th daa s 36 Europan Cnral Bank working papr sris 37 ECB Working Papr No 163 Augus

5 Absrac: This papr uss survy daa o assss consumrs inflaion xpcaions in h uro ara. Th probabiliy approach is usd o driv quaniaiv simas of inflaion xpcaions from h Europan Commission s Consumr Survy. Th papr subsqunly analyss h mpirical propris of h simad inflaion xpcaions by considring h xn o which hy fulfil som of h ncssary condiions for raionaliy. Th rsuls suggs an inrmdia form of raionaliy. In paricular, h survyd xpcaions ar an unbiasd prdicor of fuur pric dvlopmns and hy incorpora hough no always complly a broad s of macroconomic informaion. In addiion, alhough prsisn dviaions bwn consumrs xpcaions and h raional oucom hav occurrd, consumrs ar shown o raionally adjus hir xpcaions in ordr o vnually wd ou any sysmaic xpcaional rrors. Inrsingly, prhaps rflcing changs in h monary rgim, hr is also vidnc of growing raionaliy ovr h 1990s compard wih h 1980s. Ky words: Inflaion xpcaions, Survys, Raionaliy, Euro ara JEL Classificaion: D12, D84, E31 4 ECB Working Papr No 163 Augus 2002

6 Non chnical summary Macroconomic hory accords a pivoal rol o xpcaions of inflaion, and h propris of hos xpcaions, in undrsanding h funcioning of h conomy. From h prspciv of aggrga pric formaion, h xpcaions augmnd Phillips curv posis a rlaionship whrby h acual chang in h pric lvl is drivn - in par - by xpcaions of is fuur chang. Convrsly, from h prspciv of businss cycl analysis, a ky prdicion is ha h scal of any ral simulus o h conomy from inflaion will crucially dpnd on h xn o which such inflaion is anicipad. Undr fully raional xpcaions, whr agns form hir xpcaions by corrcly aking ino accoun all h rlvan informaion and whr hr ar no sysmaic rrors in agns forcass of inflaion, only unxpcd changs in inflaion will hav an impac on ral variabls such as oupu and unmploymn. In his papr a masur of xpcd inflaion in h uro ara is drivd from h Europan Commission s Consumr Survy (EC survy). In ordr o shd ligh on h raionaliy of inflaion xpcaions in h uro ara, h propris of h drivd sris ar xamind and assssd along a numbr of dimnsions. Firsly, w considr whhr or no consumrs hav corrcly anicipad h inflaion oucom on avrag by sing for any bias in h survy indicaor. Scond, w considr h dynamic adjusmn propris of xpcaions and, in paricular, provid simas of h spd wih which consumrs rvis hir xpcaions o b in lin wih h fully raional oucom. Lasly, in a s of h fficincy of consumrs inflaion xpcaions in h uro ara, h xn o which hy incorpora h informaion conaind in a broad s of macroconomic variabls is valuad. Our rsuls suggs ha consumr xpcaions from h EC survy provid imporan informaion on acual fuur dvlopmns in uro ara inflaion. In paricular hy provid an unbiasd prdicor of inflaion on-yar ahad and, mos srikingly, corrcly anicipad h rnd dclin in inflaion ovr h 1990s. In lin wih his, our analysis of h dynamic adjusmn of xpcaions suggss ha consumrs rvis hir xpcaions in h ligh of nw informaion and ha, whil boh acual and xpcd inflaion may drif apar in h shor-run, consumrs gradually adjus hir xpcaions so as o wd ou any sysmaic rrors. Howvr, hr is som ECB Working Papr No 163 Augus

7 vidnc o suggs ha consumrs xpcaions ar no fully raional wih rspc o all h availabl informaion. In paricular, whil consumrs appar o ak full accoun of pas dvlopmns in inflaion, h mpirical vidnc suggss ha a widr s of macroconomic informaion (mos noably monary and financial variabls) can xplain consumrs rrors in forcasing inflaion. Givn h monary policy sragy ha has bn adopd by h ECB, h fac ha consumrs do no adqualy ak accoun of monary variabls (such as M3) is of inrs. In paricular, such rsuls nd o suppor h indpndn and incrmnal informaion rol ha is assignd o M3 undr h firs pillar of h sragy. Lasly, prhaps rflcing changs in h monary policy rgim, hr is vidnc of growing raionaliy of uro ara inflaion xpcaions in h 1990s compard wih h 1980s. This improvmn is paricularly noabl during h priod of convrgnc in prparaion for Economic and Monary Union and, in paricular, in h mannr in which consumrs anicipad h rnd dclin in inflaion ovr his priod. Par of h xplanaion for his may indd b ha consumrs hav bcom br a prdicing inflaion. Howvr, uro ara inflaion has also dclind ovr h las dcads and has bcom lss volail. This, in combinaion wih grar cnral bank crdibiliy, may hav mad i asir o prdic fuur inflaion. 6 ECB Working Papr No 163 Augus 2002

8 1. Inroducion Cnral banks hav long had an inrs in monioring h bhaviour of inflaion xpcaions in h conomy and in undrsanding h naur of h procss by which xpcaions ar formd. Two simpl xampls srv o highligh h crucial imporanc of accss o rliabl masurs of xpcd inflaion: Firs, o h xn ha hy provid a usful or unbiasd prdicor of fuur inflaion, masurs of xpcd inflaion may rprsn an imporan informaion variabl in a forward-looking analysis of pric dvlopmns. Scond, highr xpcaions of inflaion may lad mploys o dmand highr wag slmns, giving ris o cos-push ffcs on inflaion. Morovr in a siuaion whr ovrall inflaion is xpcd o ris firms may b mor willing o pay highr wags bcaus hy bliv ha hy can mor asily pass on any chang in coss in h form of highr slling prics. 1 Mor fundamnally, howvr, macroconomic hory accords a pivoal rol o xpcaions of inflaion in undrsanding h funcioning of h conomy. From h prspciv of aggrga pric formaion, h Phlps-Fridman xpcaions augmnd Phillips curv posis a rlaionship whrby h acual chang in h pric lvl is drivn - in par - by aggrga xpcaions of is fuur chang. Convrsly, from h prspciv of businss cycl analysis, naural ra hory prdics ha h scal of any ral simulus from inflaion will crucially dpnd on h xn o which such inflaion is anicipad. Undr fully raional xpcaion, wih no sysmaic rrors in forcasing inflaion, only unxpcd changs in inflaion hav an impac on ral variabls such as oupu and unmploymn. Mor rcnly, h imporanc of inflaion xpcaions for aggrga pric dynamics has bn givn rigorous microconomic foundaions by considring h opimal pric-sing bhaviour of firms in a dynamic framwork undr imprfc compiion and som consrain on h frquncy of pric adjusmn (s, for xampl, 1 Chrisiano and Gus (2000) rm his h cos-push vrsion of h xpcaions rap hypohsis bcaus i poss a dilmma o h cnral bank which mus choos bwn producing h inflaion ha firms wan or risking puing h conomy ino a rcssion. Thr ar numrous ohr xampls of h rlvanc of inflaion xpcaions from a cnral bank s prspciv. Mos noably, inflaion xpcaions can b viwd as a drminan of mony dmand and hy ar likly o play an imporan rol in h monary ransmission mchanism (.g. by ffcing ral inrs ras). In h rcn liraur on monary policy ruls, inflaion xpcaions hav also bn posid o b among h ky argumns in a cnral banks ECB Working Papr No 163 Augus

9 Robrs (1995), Sbordon (2002) and (2000), Galí and Grlr (1999) and Galí, Grlr and Lópz-Salido (2001). 2 A dfining faur of his Nw Kynsian hory of pric dynamics is ha inflaion is a forward-looking phnomnon, drivn by is own xpcaions. 3 In a rcn conribuion, Taylor (2000) has argud ha his xpcaions hory of pricing can hlp xplain h obsrvd lowr ras of inflaion in many indusrialisd counris in h 1990s compard wih h 1980s and h 1970s. 4 Similarly in a rcn mpirical analysis, Galí, Grlr and Lópz-Salido (2001) find ha forwardlooking bhaviour is dominan in shaping h dynamics of inflaion (p. 17) boh in h uro ara and in h Unid Sas. All his srvs o mphasis h imporanc aachd o masurs of xpcd inflaion in macroconomic analysis. No surprisingly, a larg body of mpirical liraur xiss sking o boh sima and xamin h mpirical propris of inflaion xpcaions. On rack in his liraur has bn o focus on dirc survy masurs of xpcaions. Whil much of his liraur das from h 1970s and h 1980s, hr has bn a rlaiv darh of mpirical rsarch xamining daa from h 1990s (s, for xampl, Lloyd, 1999). 5 Givn h significan diffrnc in h bhaviour of inflaion in h 1990s compard wih h prcding wo dcads, and h possibl rol of inflaion xpcaions in xplaining hs dvlopmns, hr is a nd for mor up-o-da vidnc on h propris of survy masurs of inflaion xpcaions and paricularly givn h racion funcion (s Taylor, 1999). Inflaion xpcaions, paricularly ovr mdium-rm horizons, also provid informaion on h crdibiliy of a cnral bank s commimn o achiving pric sabiliy. 2 Wolman (1999) provids a rcn rviw of nw Kynsian horis of inflaion. 3 Th nhusiasm for his Nw Kynsian hory of pric dynamics is by no mans univrsal. For insanc, Fuhrr (1997a) using US daa finds ha xpcaions of fuur pric changs ar unimporan in xplaining pric and inflaion bhaviour. Similarly, Fuhrr (1997b) argus ha h fi of such Nw Phillips curvs can b rouinly improvd by adding lags of inflaion. As a rsul, h inflaionary procss xhibis a high dgr of prsisnc whrby h ffcs from a on-im shock will las wll byond h lifim of h iniial shock. Mor rcnly, again for h US, Robrs (2001) finds ha h Nw Kynsian modl rquirs addiional lags of inflaion ha suggs ha som fracion of h populaion uss a simpl univaria rul for forcasing inflaion. 4 Using a simpl saggrd pricing modl wih mark powr, Taylor (2000) illusras h crucial rol of xpcaions. In paricular, h shows ha h xn o which a firm machs an incras in coss or an incras in anohr firm s pric dpnds posiivly on how prsisn such changs ar xpcd o b. In ohr words, a dclin in prsisnc of ihr coss or inflaion may b associad wih a dclin in obsrvd mark powr. 5 Som noabl rcn xcpions ar Brk (1999) and Brk (2000), Robrs (1998), Gran and Lloyd (1998). S also Dusch Bundsbank (2001). 8 ECB Working Papr No 163 Augus 2002

10 adopion of a singl currncy by wlv mmbr sas of h Europan Union of xpcaions in h uro ara. This papr conribus o his rnwd inrs in survy-basd masurs of inflaion xpcaions for h spcific cas of h uro ara. 6 In paricular, a masur of xpcd inflaion in h uro ara is drivd from h Europan Commission s Consumr Survy (EC survy) and is prdiciv prformanc for fuur inflaion in xamind. Following on from his, in ordr o shd ligh on h raionaliy of inflaion xpcaions in h uro ara h propris of h drivd sris ar xamind and assssd along a numbr of dimnsions. Firsly, w considr whhr or no consumrs hav corrcly anicipad h inflaion oucom on avrag by sing for any bias in h survy indicaor. Scond, w considr h dynamic adjusmn propris of xpcaions and, in paricular, provid simas of h spd wih which consumrs rvis hir xpcaions o b in lin wih h fully raional oucom. Lasly, in a s of h fficincy of consumrs inflaion xpcaions in h uro ara, h xn o which hy incorpora h informaion conaind in a broad s of macroconomic variabls is valuad. To anicipa our findings, our rsuls suggs ha consumr xpcaions from h EC survy provid imporan informaion on acual fuur dvlopmns in uro ara inflaion. In paricular hy provid an unbiasd prdicor of inflaion on-yar ahad and, mos srikingly, corrcly anicipad h rnd dclin in inflaion ovr h 1990s. 7 In lin wih his, our analysis of h adjusmn of xpcaions suggss ha consumrs rvis hir xpcaions in h ligh of nw informaion and ha, whil boh acual and xpcd inflaion may drif apar in h shor-run, hy ulimaly rvr oward on anohr. Lasly, hr is also som vidnc o suggs ha consumrs xpcaions ar no fully raional wih rspc o all h availabl informaion. In paricular, whil consumrs appar o ak full accoun of pas dvlopmns in inflaion, h mpirical vidnc suggss ha a widr s of macroconomic informaion (mos noably monary and 6 In his papr, anion is focussd on h propris of an aggrga masur of xpcaions in h uro ara and any possibl hrogniy in h propris of inflaion xpcaions across h individual uro ara counris, alhough ponially imporan, is ovrlookd. ECB Working Papr No 163 Augus

11 financial variabls) can xplain consumrs rrors in forcasing inflaion. In his sns, xpcaions ar wak bu no srong-form fficin. Nonhlss, hr is vidnc of growing raionaliy ovr h sampl priod: whn daa from h la 1980s is xcludd from h sampl, h vidnc agains srong-form fficincy is much wakr. 2. Esimaing uro ara inflaion xpcaions from survy daa Economic survys provid a dirc sourc of informaion on xpcd inflaion. 8 For xampl, h EC Survy asks approximaly 50,000 consumrs in h uro ara for informaion on hir xpcaions for consumr pric rnds ovr h nx wlv monhs. Th survy is conducd a a naional lvl, and h rsuls for h uro ara ar compild by aggrgaing h counry daa using wighs basd on ach counry s shar in oal uro ara GDP. Paricipans in h survy ar askd h following qusion, which is harmonisd across all counris: 9 By comparison wih wha is happning now, do you hink ha in h nx 12 monhs 1. hr will b a mor rapid incras in prics, 2. prics will incras a h sam ra, 3. prics will incras a a slowr ra, 4. prics will say abou h sam or 5. prics will fall slighly. Whil h rsuls of his survy ar usually summarisd in h form of a balanc saisic, compud as a diffrnc among h proporion of rspondns oping for h diffrn rspons cagoris, his provids only qualiaiv informaion on h likly dircion of chang in inflaion in h nx 12 monhs. 10 Howvr, rcn liraur (.g. 7 This is sriking bcaus purly backward looking or adapiv xpcaions would nd o sysmaically ovr-prdic inflaion whn i is dclining. 8 Th ohr main sourc is o driv inflaion xpcaions from h prics of radd financial asss. A common argumn favouring such masurs is ha hy ar likly o rflc h ru blifs of conomic agns whras rspondns o survys hav lil incniv o rpor hir ru xpcaions or h xpcaions upon which hy bas conomic dcisions. 9 Rspondns ar also givn h opion o rply ha hy do no hav any opinion abou h fuur bhaviour of prics. 10 Dnoing S i (for i = 1,2 3, 4 and 5) as h sampl proporions oping for ach of h fiv rspons cagoris, on widly rpord balanc saisic is calculad as (S 1 +½S 2 ) - (½S 4 +S 5 ). 10 ECB Working Papr No 163 Augus 2002

12 Brk, 1999 and Brk, 2000), building on h arlir conribuions of Carlson and Parkin (1975), Bachlor (1981, 1982 and 1986a) and Bachlor and Orr (1988) and ohrs, has furhr dvlopd h probabilisic approach o obaining a quaniaiv sima of h xpcd ra of inflaion from qualiaiv survys such as hos carrid ou by h Europan Commission. An imporan faur of hs rcn advancs in mhodology is ha, unlik arlir approachs, unbiasdnss is no imposd in driving a masur of xpcd inflaion. 2.1 Th probabiliy approach o simaing inflaion xpcaions Th cnral ida bhind h probabiliy approach is o inrpr h shar of rspondns rplying o ach cagory as maximum liklihood simas of aras undr h dnsiy funcion of aggrga inflaion xpcaions, i.. as probabiliis (s Figur 1 in Annx 1). Th disribuion is sgmnd by various rspons hrsholds. For xampl, as in h original Carlson and Parkin (hrafr CP) mhodology, rspondns xpc prics o ris (fall) if h xpcd ra of inflaion for monh ( π ) bu survyd in monh -12 (for monhly daa) is a las ε unis abov (blow) zro. 11 In addiion, rspondns ar assumd o condiion hir rplis on hir prcpions of pas inflaion. In paricular, rspondns rpor ha prics ar xpcd o incras a a mor (lss) rapid pac if h xpcd ra of inflaion is a las δ unis abov (blow) h currnly prcivd ra of p inflaion a h im h survy was carrid ou ( π ). 12 On opion o sima h prcivd inflaion ra is o us h currnly availabl ra of inflaion, i.. o assum ha rspondns corrcly prciv h acual ra of inflaion a h im hy form hir xpcaions. Howvr, i is a qui srong assumpion o assum P ha consumrs prciv inflaion corrcly and, hrfor, in his papr π is simad Thr is som ambiguiy as o whhr or no h qusion in h consumr survy in monh -12 rfrs o h xpcd yar-on-yar ra of pric incras in monh or h xpcd avrag ra of inflaion in h 12 monh priod bwn monhs -12 and. Throughou his papr, h consumr survy is assumd o rfr o h formr. ECB Working Papr No 163 Augus

13 indpndnly using h rsuls from a qusion on pas pric dvlopmns also conaind in h Commissions survy. 12 Using h abov framwork, condiional on an assumd form of h aggrga disribuion, i is possibl o solv for h lvl of h xpcd inflaion ra, is sandard rror ( σ ) as wll as for h wo rspons hrsholds ( ε and δ ). Dnoing i S (for i = 1,2 3, 4 and 5) as h sampl proporions oping for ach of h fiv rspons cagoris in h survy undrakn in monh, h soluions ar givn by quaions (2.1) o (2.4) blow p ( Z 12 + Z 12 ) π = π Z 12 + Z 12 Z 12 Z 12 (2.1) p 2 σ = π Z 12 + Z 12 Z 12 Z 12 (2.2) δ 1 2 p ( Z + 12 Z 12 ) = π Z 12 + Z 12 Z 12 Z 12 (2.3) ε 3 4 p ( Z 12 Z 12 ) = π Z 12 + Z 12 Z 12 Z 12 (2.4) Whr all variabls ar dfind prviously and σ dnos h sandard dviaion of h aggrga disribuion for inflaion xpcaions. N -1 [] is h invrs of h assumd probabiliy disribuion funcion and Z 12 = N [ 1 S 12 ], 12 = N [ 1 S 12 S 12 ] Z N [ S S S ] and Z N [ S ] 12 = = 12 Z,. Th abov xprssions for h man and sandard rror of xpcd fuur inflaion ar qui similar o h original CP rsuls. Thy xprss h man and h uncrainy of xpcd inflaion as a funcion of h i Z 12 and h prcivd ra of inflaion, which has a scaling funcion. Howvr, in 12 Th qusion on pas pric dvlopmns asks consumrs h following: Compard wih wha i was 12 monhs ago, do you hink ha h cos of living is now 1. Vry much highr, 2. Qui a bi highr, 3. A lil highr, 4. Abou h sam, 5. Lowr or 6. Don know. 13 S h Appndix in Brk (1999) for a full drivaion and furhr discussion of hs quaions. 12 ECB Working Papr No 163 Augus 2002

14 conras o h original CP approach, whr h scaling paramr was simad by imposing unbiasd xpcaions, an imporan advanag of quaion (2.1) is ha i dos no impos unbiasdnss as an a priori propry of h masur of xpcaions. 14 This facilias subsqun mpirical sing of h xn of any bias in h inflaion xpcaions of consumrs. Howvr, a disadvanag of h probabiliy approach is ha i may giv ris o counrinuiiv movmns in h drivd xpcaions sris. For xampl, on would xpc ha a cris paribus incras in h shar of rspondns xpcing prics o ris a a mor rapid pac (.g. as a rsul of a dclin in h shar of rspondns giving a don know rply) would b associad wih a highr quaniaiv sima of xpcd inflaion. Howvr, considraion of h parial drivaiv of π in (2.1) wih rspc o S 1 12, shows ha his is no ncssarily h cas. 15 A scond imporan advanag compard wih h CP mhodology is ha h rspons hrsholds ar prmid o vary ovr im. Such im-variaion may rprsn an imporan faur of h problm facd by consumrs in rsponding o h survy. Bachlor (1986b) providd argumns for im-varying rspons hrsholds basd on signal xracion hory, suggsing ha h rspons hrshold will nd o b high whn h aggrga uncrainy surrounding inflaion is also high. Similarly, Siz (1988) modls h rspons hrsholds as a linar funcion of h acual inflaion ra and h disprsion of pric changs across indusris. In conras, h abov masurs prmi im-varying rspons hrsholds o b drivd dircly from h survy rplis wihou h nd o mak any ad hoc assumpions on hir drminans. 2.2 Rsuls for h uro ara Char 1 plos h drivd masur of inflaion xpcaions in h uro ara oghr wih h acual yar-on-yar ra of incras in h Harmonisd Indx of Consumr Prics (HICP) ovr h priod January 1986 o Fbruary 2001 (s Annx 2 for a full dscripion 14 Bachlor (1982) suggss a las squars rahr han an unbiasdnss cririon, i.. by choosing a scaling facor such ha h sum of squard xpcaion rrors is minimisd. 15 S Bachlor, 1986a, for a discussion of his problm. ECB Working Papr No 163 Augus

15 of h daa sourcs). 16 Th rsuls suggs a srong rlaionship bwn acual and xpcd inflaion. In paricular, alhough hr is som vidnc o suggs ha consumrs undrprdicd inflaion in h scond half of h 1980s, hy appar o hav broadly anicipad h rnd dclin in inflaion ovr h cours of h 1990s (from a high of 5.2% in July 1991 o only 0.8% in Fbruary of 1999). Indd, ovr h priod from h bginning of h 1990s o h sar of Economic and Monary Union in January 1999, h vidnc suppors a significan dgr of forward-looking informaion in h drivd xpcaions sris. In paricular, consumrs appar o hav prformd much br han if hy had aachd a vry high wigh o pas inflaionary rnds whn forming hir xpcaions. For xampl, in January of 1992, inflaion had avrag 4.3% ovr h prcding yar. Howvr, in ha sam monh consumrs wr anicipaing an inflaion ra of 3.2% for h nx 12 monhs and his compard mor favourably wih h acual oucom for January 1993 (3.4%). This parn is rpad ovr much of h 1990s. Hnc, i suggss a rasonably raional anicipaion of h rnd dclin in inflaion ha would no hav bn possibl if consumrs simply would hav xrapolad in a backward-looking mannr pas inflaion whn forming hir xpcaions. To provid a mor quaniaiv valuaion of h xpcaions sris, Tabl 1 prsns som sandard forcas prformanc saisics. Th firs saisic is h man rror (ME), which shows h avrag forcas rror ovr h sampl priods. Hnc, a larg man rror provids vidnc of sysmaic ovr- or undr-prdicion. Th scond masur is h man absolu rror (MAE), which says somhing abou h accuracy of h consumrs xpcaions as a prdicor of h fuur inflaion oucom. Larg bu counrbalancing forcas rrors would produc a low man rror bu a highr man absolu rror. Th hird masur is h roo man squard rror (RMSE), which also provids a masur of accuracy. An imporan diffrnc bwn h MAE and h RMSE is ha h formr is lss snsiiv o vry larg xpcaional rrors or oulirs. For comparison rasons h prformanc masurs hav also bn calculad for wo alrnaiv masurs of xpcaions: (i) a naiv xpcaion which simply xrapolas 16 Th xpcaions rpord for monh in char 1 wr formd in monh -12. Hnc, h diffrnc in h wo lins in Char 1 rprsns h forcas rror. 14 ECB Working Papr No 163 Augus 2002

16 h currn yar-on-yar ra as h xpcaion for h nx wlv monhs ( π = π 12 ) and (ii) a proxy for financial mark xpcaions drivd from a Fishr rlaion for h 1- yar ahad mony-mark inrs ra. 17 Consisn wih h graphical vidnc in Char 1 ha prformanc has improvd in h 1990s compard wih h 1980s, h sampl is spli ino wo sub-priods. This spli is also moivad by h obsrvd dclin in inflaion ovr h pas dcads, which may hav changd h inflaionary procss and, hrby, also h bhaviour and forcasing prformanc of consumrs inflaion xpcaions. Th chosn brak (1992:12) rprsns approximaly h mid-poin of h sampl. Th prformanc saisics ar hn calculad for h whol sampl as wll as for ach subsampl. Th prformanc saisics in Tabl 1 indica qui srongly h chang in h prformanc of h drivd xpcaion sris in h 1990s compard wih h la 1980s. From h abl i is clar ha any bias in xpcaions rlas almos nirly o h la 1980s wih h man rror falling from 0.94 ovr h priod 1986:1-1992:12 o only 0.06 in h priod 1993:1-2000:12. Similarly, hr is a dramaic improvmn in accuracy saisics in h scond sub-sampl compard wih h firs: in h 1990s boh h MAE and h RMSE ar around 40% of hir lvls in h la 1980s. Indd a sriking faur of h survyd xpcaions for h uro ara is hir rlaiv prcision as a prdicor of on-yar ahad inflaion compard wih h wo ohr bnchmarks ovr h 1990s. Mos noably, hy significanly ouprform h xpcaions basd on h naiv modl and hos drivd from h Fishr rlaion. Th prformanc of h masur of consumr xpcaions also compars rasonably wll wih hos rpord for masurs of US inflaion xpcaions. For xampl, Lloyd (1999) for h US obains RMSE for various on-yar ahad inflaion xpcaions ha rang bwn 1.09 and Lasly, 17 In ordr o calcula a masur of xpcaions from h 1-yar inrs ra, h ral inrs ra is simad as a wighd moving avrag of h pas wlv x pos ral ras whr h wighs diminish wih h lag lngh, i.. π = i ra and w i is h wigh which is dfind as wi ( i 12 i π 12 i ) i= 0 18 Ths wr calculad ovr h priod 1983:3-1997:4. w i 12 i =, whr 78 i=, whr i -12 is h 12-monh nominal inrs 11 0 w = 1. i ECB Working Papr No 163 Augus

17 in rms of accuracy, h xpcaions sris also compar rasonably favourably wih h ou-of-sampl forcass of various indicaor modls for inflaion. For US inflaion s, for xampl, Ccchi (1995) and Ccchi, Chu and Sindl (2000). For uro ara inflaion s Nicoli Alimari (2001). In ordr o compl h prsnaion of h rsuls from applying h probabiliy approach o h uro ara consumr survy, Char 2 plos h sima of uncrainy ( σ ) along wih h simad rspons hrsholds ( ε and δ ) ovr h priod 1985:1 2000:12. Inflaion uncrainy ( σ ) appars o hav rndd down somwha ovr h 1990s from a high of ovr 2.5 prcnag poins in Ocobr 1990 o 1.1 prcnag poins in January This suggss a high dgr of corrlaion bwn uncrainy surrounding xpcd fuur inflaion and h lvl of acual inflaion. Inflaion uncrainy did, howvr, incras abruply following h oil shock in arly As rgards h rspons hrsholds, hy also corrla posiivly boh wih ach ohr and wih h masur of uncrainy. 3. Propris of uro ara inflaion xpcaions Th vidnc dscribd in scion 2 suggss ha h masur of xpcaions drivd from h EC survy provids ponially usful informaion on acual fuur pric dvlopmns compard wih som simpl bnchmark alrnaiv masurs. In his scion, h propris of h drivd masur of xpcaions ar xamind mor formally. W firs rpor h rsuls of rgrssion-basd ss for unbiasdnss - a ncssary condiion for raionaliy. Howvr, ss of bias shd ligh only on h bhaviour of xpcaions on avrag. Hnc, w also considr h dynamic propris of xpcaions and, in paricular, mploy im sris chniqus in ordr o invsiga h spd wih which xpcaions ar rvisd ovr im in h ligh of nw informaion. Following on from his, h wak and srong-form fficincy of xpcaions is invsigad by sing h xn o which h xpcaions incorpora h informaion conaind in pas pric dvlopmns as wll as ha conaind in a broadr s of macroconomic variabls availabl a h im h xpcaions ar formd. 16 ECB Working Papr No 163 Augus 2002

18 3.1 Long-run propris: Tsing for bias Bias rfrs o h limiing propris of xpcaions. In paricular, biasd xpcaions imply ha consumrs, on avrag, sysmaically undr or ovrprdic inflaion ovr h long run. A formal s for bias in h xpcaions sris can b carrid ou using h following quaion: π = α + βπ + u, (3.1) whr π is h obsrvd inflaion ra in monh and π rprsns xpcaions for inflaion in monh bu formd in monh -12. If h join null hypohsis H 0 : (, ) = (0,1) canno b rjcd i can b concludd ha h xpcaions ar unbiasd in a saisical sns. In lin wih h prvious vidnc of an improvd prformanc of h xpcaions indicaor in h 1990s compard wih h 1980s, a Chow brakpoin s conducd on quaion (3.1) confirms ha a srucural brak has occurrd in h rlaion bwn consumrs xpcaions and acual inflaion. 19 Hnc, h hypohsis of unbiasd inflaion xpcaions is conducd for h full sampl priod and h wo subsampl priods as dfind arlir. Th rsuls ar prsnd in Tabl 2. Ovrall, h rsuls suggs ha consumrs inflaion xpcaions hav bn an unbiasd prdicor of inflaion 12 monhs ahad. Ovr h full sampl, h null hypohsis canno b rjcd a a rasonabl lvl of significanc. Howvr, looking a h rsuls for h firs sub-priod, h null hypohsis is rjcd hus confirming h prvious finding of poor prformanc in h la 1980s. Th posiiv suggss ha xpcaions hav on avrag undrsimad inflaion and, in addiion, is wll blow uniy. In conras, for h scond sub-sampl h unrsricd paramr simas accord almos xacly wih hir horical valus undr h null hypohsis of unbiasd xpcaions. Morovr, if a similar s is conducd bu rplacing h drivd xpcaion sris wih xpcaions basd on a naïv modl h null hypohsis of unbiasd xpcaions is rjcd for all of 19 Th s srongly rjcs h null hypohsis of no srucural chang wih a log likly raio of 91.91, which is o b compard wih h criical valu of ECB Working Papr No 163 Augus

19 h hr sampl priods. 20 This finding is consisn wih h viw ha h inflaion xpcaions ar mor raional compard wih a simpl modl ha jus xrapolas pas oucoms. 3.2 Dynamic propris: Th adjusmn of xpcaions Th abov simpl ss for bias shd ligh on h qusion of whhr or no on avrag h drivd masur of consumrs inflaion xpcaions provid an accura sima of inflaion 12 monhs ahad. Howvr, ss of bias do no shd any ligh on h dynamics of h xpcaions formaion procss ovr im. From a mor dynamic prspciv, an imporan issu is h xn o which consumrs rvis hir xpcaions o rflc h flow of nw informaion, including hir knowldg of hir own prvious forcas rrors. A common ariculaion of h raional xpcaions hypohsis is ha nonovrlapping rrors in prdicing inflaion should b uncorrlad - ohrwis consumrs could hav improvd hir xpcaions by aking br accoun of hir pas rrors. In h prsn conx wih monhly daa on xpcaions for on-yar ahad, h rrors ar ovrlapping and his may induc som posiiv auocorrlaion alhough his should dampn ou for lags grar han 12. Th viw ha h forcas rrors of raional agns should b broadly uncorrlad for lags grar han 12 is no undispud. For xampl, sinc h procss gnraing aggrga inflaion is uncrain, Cuckirman (1986) argud ha vn prfcly raional agns may no b abl o disinguish prmann from ransiory shocks. If his is h cas and if prmann shocks ar misaknly prcivd o b ransiory, agns may mak rpad on-sidd rrors in forming hir xpcaions (s also Lloyd, 1999). Th vidnc from h EC consumr survy is broadly consisn wih his viw. For xampl, Char 3 rpors h auocorrlaion funcion for hs rrors and whil hy dcay gradually ovr im, hr dos appar o b som posiiv auocorrlaion for lags grar han 12. Howvr, vn if uncrainy abou h naur of h shocks ffcing h inflaionary procss may giv ris o such prsisnc in xpcaional rrors, hy should 20 A s of unbiasdnss of naïv xpcaions uss h rgrssion π = α + βπ 12 + u. Th χ 2 saisics for h full sampl, h firs and scond sub-sampls ar 31.97, and rspcivly and 18 ECB Working Papr No 163 Augus 2002

20 no prsis indfinily. In paricular, as argud in McCallum (1980), bcaus rrors ar cosly (.g. hy can lad o poor dcisions) purposful agns hav an incniv o acquir sufficin informaion o wd ou sysmaic xpcaional rror (s also Carlson, 1987). Tim sris conomrics and, in paricular, coingraion analysis suggs an insighful way o invsiga h dynamic propris of inflaion xpcaions and, in paricular, h spd wih which consumrs rvis hir xpcaions o ak accoun of h flow of nw informaion and wd ou any sysmaic rror. If acual and xpcd inflaion ar coingrad wih coingraing vcor [1,-1], i is possibl o sima an rror corrcion modl whrby h adjusmn of xpcd inflaion oward is fully raional valu can b xamind. 21 Th adjusmn paramr from h rror corrcion modl rvals imporan informaion on h xn and spd wih which consumrs adjus hir xpcaions oward h fully raional oucom. In addiion, wihin such a framwork, i is also insighful o s whhr hr is any fdback from xpcd inflaion o h acual inflaion oucom. Givn his ponial for fdback in boh dircions, w firs s for h xisnc of a coingraing rlaion bwn acual and xpcd inflaion. In a scond sp, a bi-varia rror corrcion sysm of h form givn by (3.1) blow is simad and is dynamic propris xamind. π = p p o + φi π i + ψ i π i + α [ π π 1 1 i= 1 i= 1 α ] + ε (3.1a) p p π = α o + φi π i + ψ i π i + α [ π π ] + ε 1 1 i= 1 i= 1 (3.1b) Undr h hypohsis of coingraion, on of h α, α An inrsing faur of his sysm is ha h quaion for xpcaions has a forward-looking dimnsion. In hs all imply a clar rjcion of unbiasdnss a sandard significanc lvls. 21 Ohr rcn paprs applying coingraion chniqus o shd ligh on h raionaliy of xpcaions includ Gran and Lloyd (1998), Du and Ghosh (2000), Brk (1999) and (2000). S also Paqu (1992). 22 Grangr (1988) poind ou ha, if wo sris ar coingrad, hn hr mus b Grangr causaliy in a las on dircion. ECB Working Papr No 163 Augus

21 paricular, in h cas of quaion (3.1a), h s of h hypohsis α 0 ss whhr h chang in xpcaions (formd bwn priods -13 and -12) is such ha h lvl of inflaion xpcd for priod will b closr o h raional oucom (which is unknown a h im xpcaions wr formd). In h cas of quaion (3.1b), h s of h hypohsis α 0 xamins whhr h chang in acual inflaion also adjuss in ordr o mainain a coingraing rlaion wih xpcd inflaion. Wihin such a sysm, i is also possibl o s for addiional shor-run dynamic ffcs associad wih h cofficins φ, i, ψ i φi and i ψ and o compu h dynamic impuls rspons of ihr variabl following an orhogonalisd shock o h quaions rsiduals ( ε, ε ). As h prliminary sp in sing for h xisnc of such an rror corrcion rprsnaion, Tabl 3 rpors sandard uni roo ss for boh acual and xpcd inflaion ovr h priod In gnral, h ss suggs ha boh acual and xpcd inflaion hav uni roos bu ha hy ar saionary whn diffrncd onc. Howvr, i is possibl o rjc h null hypohsis of a uni roo in h xpcaion rror suggsing ha boh acual and xpcd inflaion coingra wih known coingraing vcor [1, -1]. 23 In a scond sp, h bi-varia rror corrcion modl (3.1a and 3.1b) is simad. Consisn wih h monhly frquncy of h daa, h lag lngh p is s qual o wlv. 24 Th quilibrium corrcion cofficins ( α o, α o ) and F-ss for Grangrcausaliy associad wih h paramrs φ, i, ψ i φi and i ψ ar rpord in Tabl 4 for boh h full and wo sub-sampls idnifid arlir. In h rgrssion for h chang in xpcaions, h adjusmn paramr on h xpcaional rror is significan and suggss ha consumrs rvis hir xpcaions and adjus hm oward h fully raional oucom. In rms of h spd of his adjusmn, givn h monhly frquncy 23 Addiional ss also suppor h hypohsis of coingraion bwn acual inflaion and h ra xpcd by consumrs. In paricular, using Johansn s maximum liklihood chniqu, boh h maximum ignvalu and rac saisics (s Hansn and Juslius, 1995) suppor h hypohsis of a singl coingraing vcor a h 90% lvl. 24 This was h lows numbr of lags ha was consisn wih srially uncorrlad rsiduals in h bivaria sysm. 20 ECB Working Papr No 163 Augus 2002

22 of h daa, h simad co-fficin (-0.05) implis qui low prsisnc in dviaion of acual and xpcd inflaion. 25 Ovrall hrfor, hs rsuls suggs ha consumrs rac qui quickly whn rvising hir xpcaions in h ligh of nw informaion and ha, whil boh acual and xpcd inflaion may drif apar in h shor-run, hy ulimaly rvr oward on anohr. Considring h ohr adjusmn cofficin ( α ), whil posiivly signd i is no significan, hrby suggsing ha h adjusmn of acual inflaion plays no significan rol in mainaining h coingraing rlaion. Th finding ha xpcaions adjus owards acual inflaion, rahr han h ohr way around, suggss ha h procss gnraing inflaion is no srongly influncd by xpcaions, which in urn conrass wih Nw Kynsian horis of pric dynamics. In gnral, all of h abov findings ar robus across boh of h sub sampls considrd (1986:1 1992:12 and 1993:1-2000:12). 26 o To shd furhr ligh on h dynamic inracion bwn acual and xpcd inflaion, Tabl 4 also rpors h F-saisics for h ss ha h ohr shor-run cofficins φ, i, ψ i φi and i ψ can b xcludd from h bi-varia modl. Ths ar dnod F 1, F 2, F 3 and F 4 in Tabl 4. Th rsuls suggs a significan rol for acual inflaion as drminans of changs in xpcaions in a Grangr-causal sns (F 2 ). Howvr, h fdback from xpcaions o acual changs in inflaion is qui wak and insignifican a sandard lvls (F 3 ). Lasly, o shd furhr ligh on h adjusmn of xpcaions, Char 4 plos h dynamic impuls rsponss of boh acual and xpcd inflaion following a shock o acual inflaion. Following such a shock, hs rsponss giv h condiional forcass for h pah of boh variabls ha is implici in h bi-varia modl. 27 From h char, and consisn wih h finding ha i has a uni roo, a shock o inflaion is highly prsisn and has a prmann ffc on is lvl. Howvr, in lin 25 Absracing from h ohr shor-rm dynamics, his co-fficin implis a half-lif of dviaions from long-run quilibrium of abou 12 monhs. This vidnc is clos o ha rpord by Robrs (1998) for h US which implis ha xpcaions adjus 50% o 60% oward h fully raional oucom wihin a yar. 26 Givn h prvious vidnc of lss bias in h masur of xpcaions in h 1990s compard wih h 1980s, on surprising diffrnc is ha h adjusmn of xpcaions is simad o b fasr in h firs sub-sampl compard wih h scond. 27 Th impuls rspons funcions ar basd on h Cholski dcomposiion of h covarianc marix of h shocks. As is wll known, hy ar no uniqu and, in gnral, dpnd on which variabl is placd firs in ECB Working Papr No 163 Augus

23 wih h prcding analysis, xpcd inflaion adjuss gradually o h nw prmannly highr lvl of inflaion. Afr approximaly 12 monhs 45% of h dviaion bwn acual and xpcd inflaion has bn corrcd, whil i aks ovr 30 monhs bfor 90% of h gap bwn xpcd inflaion and is nw sady sa lvl has bn closd. Ovrall, his finding of gradual adjusmn of xpcd inflaion o is fully raional oucom is in lin wih h viw ha, whil consumrs may fac informaion problms whn forming hir xpcaions, hy vnually adjus hm in ordr o wd ou any sysmaic dviaions of xpcd inflaion from is fully raional oucom. 3.3 Simpl ss of macroconomic fficincy A mor gnral formulaion of h raional xpcaions hypohsis is ha h xpcaional rrors should b orhogonal wih rspc o h informaion s ha was known o consumrs a h im hy formd hir xpcaions, i.. h x pos rror canno b xplaind by pas conomic dvlopmns. By disinguishing bwn h brah of h informaion s ha is assumd o b availabl o consumrs, i is possibl o disinguish diffrn dgrs of fficincy. In paricular, xpcaions ar said o b wakform fficin if h xpcaional rror canno b xplaind by an informaion s ha includs only pas valus of inflaion. Srong-form fficincy, on h ohr hand, rquirs ha h xpcaional rror b orhogonal wih rspc o a much widr informaion s ncompassing many of h macroconomic variabls ha ar hough o hav an influnc on pric dvlopmns. Th fficincy of consumrs inflaion xpcaions may b sd by simaing h following quaion: π π = δ + φ Ω + u, (3.2) 12 whr Ω 12 rprsns h s of informaion variabls ha ar rlvan for prdicing inflaion and ar availabl a h im h xpcaions ar formd. In h mpirical h bi-varia sysm. Whil w rpor h impuls rsponss for a bi-varia modl in which xpcd inflaion is placd firs, h rsuls do no dpnd significanly on h ordring of h variabls. 22 ECB Working Papr No 163 Augus 2002

24 analysis, his includs pas inflaion as wll as a wid rang of ohr macroconomic indicaors capuring dmand and cos prssurs as wll as monary and financial condiions. In ordr o xploi h monhly frquncy of h xpcaions sris monhly daa ar mployd for ach of h informaion variabls if availabl. Howvr, for wags, GDP and h nominal ffciv xchang ra only a quarrly frquncy is availabl so h monhly xpcaions sris is avragd o produc simas a a quarrly frquncy. Whil in principl i is appropria o includ all variabls in a mulivaria conx his could lad o svr conomric complicaions (.g. mulicollinariy). Hnc, h fficincy of consumrs xpcaions is valuad by running a squnc of univaria rgrssions whr h dpndn variabl is h yar-on-yar chang in h informaion variabl a h im ha xpcaions wr formd. 28 A saisically significan φ suggss ha h ffc on inflaion from pas dvlopmns in h informaion variabl ( Ω 12 ) has bn ihr undr or ovr simad. Morovr, if h sign on h ru corrlaion bwn h informaion variabl and inflaion is known, i is also possibl o judg whhr a crain variabl s ffc on inflaion is ovr or undr simad by consumrs. Assuming a posiiv corrlaion bwn h informaion variabl and inflaion, a posiiv (ngaiv) φ suggss ha h ffc from ha paricular variabl on inflaion has bn undr (ovr) simad. If a ngaiv corrlaion is assumd, howvr, h inrpraion is rvrsd, i.. a posiiv (ngaiv) φ would suggs ha h ffc from ha paricular variabl on inflaion has bn ovr (undr) simad. Th consan (δ ) canno b inrprd in a maningful way. Th rsuls from h macro fficincy ss ar prsnd blow in Tabl 5. Earlir findings basd on forcasing prformanc and ss of unbiasdnss indica ha xpcaions hav bcom mor raional ovr h sampl priod. This also sms o b h cas as rgards hir fficincy. Ovr h full sampl-priod pas pric dvlopmns do no xplain consumrs prdicion rrors hrby providing vidnc of wak form fficincy. As rgards h ohr variabls, all cos indicaors, indusrial producion, h 28 Hnc, his s ignors h ffc of publicaion lags and possibl rvisions on h informaion s availabl o consumrs. ECB Working Papr No 163 Augus

25 12-monh inrs ra and h wo uro xchang ra masurs also do no xplain any of h prdicion rror. Howvr, consumrs inflaion xpcaions do no appar o b fully fficin wih rspc o h informaion conaind in h monary aggrgas or som of h ohr inrs ra variabls. Looking a h wo sub-sampls hr is, howvr, clar vidnc of a subsanial improvmn in rms of fficincy in h 1990s compard wih h 1980s. In h scond sub-sampl hr ar only wo variabls ha significanly xplain h rrors; M3 and h long-rm inrs ra. 29 For boh of hm φ is posiiv, suggsing ha consumrs hav undrsimad hir impac on inflaion (assuming a posiiv rlaionship bwn ach of hs variabls and inflaion). As rgards h formr variabl his finding is paricularly inrsing givn h monary policy sragy ha has bn adopd by h ECB. In paricular, sinc consumrs do no ak accoun of h informaion conaind in monary aggrgas whn forming hir xpcaions, h rsuls nd o suppor h indpndn and incrmnal informaion rol ha is assignd o M3 undr h firs pillar of h sragy. Ovrall, h vidnc from h fficincy ss suggss an inrmdia rahr han a full form of raionaliy wih consumrs aking ino accoun a wid ranging bu no compl s of informaion in forming hir xpcaions. In addiion, consisn wih h rsuls rlaing o bias, hr is vidnc of growing raionaliy whn h prformanc of xpcaions in h 1990s is compard wih ha in h la 1980s. Howvr, h highr dgr of fficincy in h scond sub-sampl may no only b du o grar raionaliy on h par of consumrs. Euro ara inflaion has dclind ovr h las dcads and bcom lss volail. This, in combinaion wih grar cnral bank indpndnc and crdibiliy, has mad i asir o prdic fuur inflaion. Hnc, consumrs may hav bcom mor fficin a prdicing inflaion bu policy makrs may also hav mad h job asir han i was 10 yars ago. 29 Th consisn lack of fficincy wih rspc o monary variabls ha is found for h uro ara is a odds wih h vidnc rpord in Ball and Croushor (1998) for US inflaion xpcaions. 24 ECB Working Papr No 163 Augus 2002

26 4. Conclusions Survys ar usful bcaus hy provid indpndn (or rlaivly non-modl dpndn) masurs of inflaion xpcaions, a ky variabl ha a cnral bank can us in is dsign of an opimal monary policy gard oward h achivmn of pric sabiliy. This papr analyss and asssss h mpirical propris of consumrs inflaion xpcaions in h uro ara ovr h priod from h mid 1980s o h nd of Using h approach s ou in Brk (1999), h probabiliy approach is usd o driv quaniaiv simas of uro ara inflaion xpcaions from h qualiaiv daa from h Europan Commission Consumr Survy. Th papr subsqunly analyss h mpirical propris of h simad inflaion xpcaions by considring h xn o which hy fulfil som of h ncssary condiions for raionaliy. Th rsuls suggs consumrs inflaion xpcaions in h uro ara saisfy an inrmdia rahr ha a compl form of raionaliy. Firsly, compard wih ohr bnchmark indicaors of xpcd inflaion, consumrs xpcaions ar shown o provid a rasonably accura prdicor of inflaion on-yar ahad. Scond, h survyd xpcaions ar found o b an unbiasd prdicor of fuur pric dvlopmns ovr h long-run. In lin wih his, hr is also vidnc ha h lvl of xpcd inflaion and h raional inflaion oucom ar coingrad and, as a rsul, consumrs ar shown o gradually adjus hir xpcaions in ordr o wd ou any sysmaic xpcaional rror. Lasly, consumrs xpcaions in h uro ara appar o incorpora hough no always complly h informaion conaind in a broad s of macroconomic variabls. In paricular, pas pric dvlopmns as wll as various cos and aciviy indicaors do no xplain consumrs prdicion rrors. Howvr, consumrs inflaion xpcaions do no appar o b fully fficin wih rspc o h informaion conaind in h monary aggrgas or som inrs ra variabls. This suggss ha hr is an indpndn and incrmnal rol for hs variabls in xplaining fuur inflaion, which is no akn ino accoun by consumrs whn forming hir xpcaions. Ovrall, h vidnc on fficincy of consumrs xpcaions whn combind wih h vidnc on hir unbiasdnss and h naur of h procss whrby xpcaions ar ECB Working Papr No 163 Augus

27 adjusd o convrg oward h fully raional oucom suggss an inrmdia form of raionaliy (similar o ha cid in Robrs (1998) for h US). A furhr imporan faur of h mpirical analysis has bn h invsigaion of ponial changs ovr im in h propris of h drivd xpcaions sris. In his rgard, hr is som significan vidnc of growing raionaliy in h sns ha xpcaions hav bcom a mor accura, lss biasd and mor fficin prdicor of inflaion ovr h 1990s compard wih h 1980s. This improvmn is paricularly noabl during h priod of convrgnc in prparaion for Economic and Monary Union and, in paricular, in h mannr in which consumrs anicipad h rnd dclin in inflaion ovr his priod. Par of h xplanaion for his may indd b ha consumrs hav bcom br a prdicing inflaion. Howvr, uro ara inflaion has also dclind ovr h las dcads and bcam lss volail. This, in combinaion wih grar cnral bank crdibiliy, may hav mad i asir o prdic fuur inflaion. Hnc, whil consumrs may hav bcom mor fficin a prdicing inflaion, monary policy makrs may also hav mad h job asir han i was n yars ago. Givn hs findings on h rlaivly significan and improving informaion conn of h consumr survy daa for xpcd inflaion, such daa provid a srong basis on which o carry ou furhr macroconomic rsarch on inflaion xpcaions and on how hy influnc macroconomic dvlopmns. An imporan ara for fuur rsarch rmains h furhr invsigaion of h link bwn xpcd inflaion and h acual inflaion oucom ha is suggsd by rcn nw Kynsian modls of inflaion. 26 ECB Working Papr No 163 Augus 2002

28 Rfrncs Ball, L. and D. Croushor (1998) Expcaions and h ffcs of monary policy Fdral Rsrv Bank of Philadlphia, WP 98-13, Jun Bachlor, R. A. (1981) Aggrga Expcaions undr h sabl laws Journal of Economrics, 16, Bachlor, R. A (1982) Expcaions, oupu and inflaion: Th Europan xprinc Europan Economic Rviw, 17, 1 25 Bachlor, R. A. (1986a) Quaniaiv vrsus qualiaiv masurs of inflaion xpcaions Oxford Bullin of Economics and Saisics, 48, Bachlor, R. A. (1986b) Th psychophysics of inflaion Journal of conomic Psychology, 7, Bachlor, R. A. and A. B. Orr (1988) Inflaion xpcaions rvisid Economica, 55, Brk, J. M. (1999) Masuring inflaion xpcaions: a survy daa approach Applid Economics, 3, Brk, J.M. (2000) Consumrs inflaion xpcaions and monary policy in Europ Rsarch Mmorandum, Vrij Univrsii, Amsrdam, , Jun Carlson, J. A. and M. Parkin (1975) Inflaion xpcaions Economica, 42, Carlson J. B. (1987) Larning, Raionaliy, h Sabiliy of Equilibrium and Macroconomics, Fdral Rsrv Bank of Clavland, Economic Rviw, Fourh Quarr, Ccchi, S. G. (1995) Inflaion Indicaors and Inflaion Policy NBER Macroconomics Annual, Ccchi, S. G., R. S. Chu and C. Sindl (2000) Th unrliabiliy of inflaion indicaors Currn Issus in Economics and Financ, Fdral Rsrv Bank of Nw York, 6/4, April Chrisiano, L. J. and C. Gus (2000) Th xpcaions rap hypohsis Fdral Rsrv Bank of Chicago, Economic Prspcivs, Scond Quarr, Cukirman, A. (1986) Masuring Inflaion Expcaions Journal of Monary Economics 17, ECB Working Papr No 163 Augus

29 Dusch Bundsbank (2001) Th informaion conn of survy daa on xpcd pric dvlopmns for monary policy Monhly Rpor, January, Du, S. D. and D. Ghosh (2000) Inflaion xpcaions: ar hy raional? An mpirical xaminaion Applid Economics Lrs, 7, Fagan, G., J. Hnry and R. Msr (2001) An ara wid modl (AWM) for h uro ara ECB working papr, 42, January Fuhrr, J. (1997a) Th unimporanc of Forward-Looking Bhaviour in Pric Spcificaions, Journal of Mony, Crdi and Banking, 29, Fuhrr, J. (1997b) Inflaion Prsisnc Th Quarrly Journal of Economics, 110, Gali J. and M. Grlr (1999) Inflaion dynamics: A srucural conomric analysis Journal of Monary Economics, 44, Galí, J., M. Grlr and D. Lópz-Salido (2001) Europan Inflaion Dynamics Europan Economic Rviw, 45, Grangr, C. (1988) Rcn dvlopmn in h concp of causaliy Journal of Economrics, 39, Gran, A. P. and T. B. Lloyd (1998) Inflaionary xpcaions and raionaliy rvisid Economics Lrs, 62, Hansn, H. and K. Juslius (1995), CATS in RATS Vrsion 1.00 Insallaion and Usrs Guid, Esima, IL. Lloyd, T. B. (1999) Survy Masurs of Expcd U.S. Inflaion Journal of Economic Prspcivs, 13/4, McCallum, B. T. (1980) Raional Expcaions and Macroconomic Sabilizaion Policy: An Ovrviw Journal of Mony, Crdi and Banking, XII, Nwy, W. K. and K. D. Ws (1987) "A Simpl, Posiiv Dfini Hroscdasiciy and Auocorrlaion Consisn Covarianc Marix" Economrica, 55, Nicoli Alimari, S. (2001) Dos mony lad inflaion in h uro ara ECB working papr, 63, May Paqu, A. (1992) Inflaionary xpcaions and raionaliy Economic Lrs, 40, ECB Working Papr No 163 Augus 2002

30 Robrs, J. M. (2001) How wll dos h Nw Kynsian Sicky-Pric Modl fi h daa, Board of Govrnors of h Fdral Rsrv Sysm, Financ and Economics Discussion Sris , Fbruary Robrs, J. M. (1998) Inflaion xpcaions and h Transmission of Monary Policy, Board of Govrnors of h Fdral Rsrv Sysm, Financ and Economics Discussion Sris , Ocobr Robrs, J. M. (1995) Nw Kynsian conomics and h Phillips Curv Journal of Mony, Crdi and Banking, 27, Sbordon, A. M. (2002 Prics and uni labour coss: a nw s of pric sickinss Journal of Monary Economics, 39, Sbordon, A. M. (2000b) An opimizing modl of US Wag and Pric Dynamics unpublishd manuscrip, Rugrs Univrsiy. Siz, H. (1988) Th simaion of inflaion forcass from businss survy daa Applid Economics, 20, Taylor, J. B. d. (1999) Monary policy ruls Chicago: Univrsiy of Chicago Prss Taylor, J. B. (2000) Low inflaion, pass-hrough, and h pricing powr of firms Europan Economic Rviw, 44, Wolman, A. L. (1999) Sicky Prics, Marginal Cos, and h Bhaviour of Inflaion Fdral Rsrv Bank of Richmond, Economic Quarrly, 85/4, ECB Working Papr No 163 Augus