Learning from Inflation Experiences

Ulrike Malmendier and Stefan Nagel look at inflationary expectations across generations and find expectations are anchored by experience, “…Our empirical analysis shows that individuals’ inflation expectations differ depending on the inflation process experienced during their life times. Differences in the experienced mean inflation rate and the persistence of inflation shocks generate (time-varying) differences in inflation expectations between cohorts. The experience of younger individuals is dominated by recent observations, while older individuals draw on a more extended historical data set in forming their expectations.Such learning from experience can explain, for example, why young individuals forecasted much higher inflation than older individuals following the high inflation years of the late 1970s and early 1980s. Both the mean rate of inflation and inflation persistence were particularly high in the short data set experienced by young individuals at the time. Learning-from experience complements the sticky information explanation of expectations heterogeneity put forward in Mankiw and Reis (2002) and Carroll (2003) for the same time period. For the more recent time period towards the end of our sample in 2010, our estimates imply that the perception of the persistence of inflation shocks is close to zero, particularly for young individuals. This suggests that unexpected movements in the inflation rate are currently unlikely to move inflation expectations much. As argued in Roberts (1997), Orphanides and Williams (2005a), and Milani (2007), these changes in individuals’ perceptions of persistence are likely to influence, in turn, the persistence of inflation rates….”

The basic dynamic, “…When forming macroeconomic expectations, individuals put a higher weight on realizations of macroeconomic data experienced during their life-times compared with other available historical data. As a result, learning dynamics are perpetual. Beliefs keep fluctuating and do not converge in the long-run, as weights on historical data diminish when old generations disappear and new generations emerge. Such learning from experience carries two central implications. First, expectations are history-dependent. Cohorts that have lived through periods of high inflation for a substantial amount of time have higher inflation expectations than individuals who have mostly experienced low inflation. Second, beliefs are heterogeneous. Young individuals place more weigh on recent data than older individuals since recent experiences make up a larger part of their life-times so far. As a result, different generations tend to disagree about the future. Both effects have been noticed in practice. During the high-inflation period of the late 1970s, the Chairman of the Federal Reserve Paul Volcker remarked:“An entire generation of young adults has grown up since the mid-1960’s knowing only inflation, indeed an inflation that has seemed to accelerate inexorably. In the circumstances, it is hardly surprising that many citizens have begun to wonder whether it is realistic to anticipate a return to general price stability, and have begun to change their behavior accordingly.”Both effects are also visible in Figure 1: Following years of high inflation, young people expect much higher inflation going forward than older people…”

Ulrike Malmendier and Stefan Nagel, "Learning from Inflation Experiences," University Of California, 2013, https://eml.berkeley.edu/~ulrike/Papers/InflExp_44.pdf