As the U.S. inflation rate slowed to a 5% clip in March, an economist explains the role expectations play in how inflation plays out
Even as the inflation rate begins to slowly subside—in the most recent report for March, it was down to 5%—the Federal Reserve still worries about inflation, and recently announced its seventh consecutive interest rate increase.
To get a primer on the link between interest rates, inflation, and expectations for inflation and the role they play in its growth or reduction, Tufts Now spoke with ChaeWon Baek, an assistant professor of economics who teaches graduate macroeconomic theory and undergraduate econometrics.
Tufts Now: Why has the Federal Reserve been raising interest rates, and what does it accomplish?
ChaeWon Baek: The Federal Reserve Bank has been actively raising interest rates because they want to control the inflation rate. Before the pandemic, the inflation rate was very low, at the 2% level, and it was very stable. Everyone assumed that we didn’t really have to worry about the inflation rate anymore. But that changed with the pandemic.
One very important factor that determines the current inflation rate is the expected inflation rate, and the Federal Reserve wants to manage that.
By raising interest rates, the Fed raises the cost of borrowing money, so they can cool down aggregate—or overall—demand, including housing demand. By doing so, you can control the inflation rate, which is also connected to the overall aggregate demand level. By steadily raising the interest rates, the central bank signals its willingness to fight to lower the inflation rate, which also affects expected inflation rates.
How do people form their expectations of inflation?
There are various measures of inflation expectations. Professional forecasters have their expectations, firms have theirs, and so do consumers—and they’re all quite different.
Professional forecasters are experts, and they understand the economy, so they behave pretty reasonably. For consumers, inflation expectations are very highly correlated with gasoline prices, implying that they use gas prices too much to update their inflation expectations.
That’s particularly true in the U.S., where people go to gas stations frequently. As gas prices go up or down, that generally affects consumers’ inflation expectations. Unlike professional forecasters, too, U.S. households tend to think that whenever inflation goes up, the unemployment rate goes up as well.
Do consumers’ inflation expectations play into what they purchase and how much they spend, and therefore make the inflation expectation become real?
Possibly, but it’s not really well established yet. In the literature, the results are mixed. For example, there are some studies showing that inflation expectations affect non-durable consumption like food, but not durable consumption, like cars. But some studies find the opposite, that inflation expectations matter only for durable consumption, but only for selected types of households.
Most of the studies were done in the low inflation period, where inflation didn’t really matter. If you did the same exercise now, you might have different results. But so far, the literature is very thin.
What research do you do in this field?
I am interested in how inflation expectations are formed, how they affect labor supply decisions, and how inflation itself affects real economic activity like output or consumption.
These days I’m studying how, even though consumers raise their inflation expectations, it’s possible that they interpret this inflation in different ways. I study how consumption behavior changes depending on how households interpret inflation differently.