Inflation Disagreement Weakens the Power of Monetary Policy

Ding Dong, Zheng Liu, Pengfei Wang, Min Wei

Research output: Working paper

Abstract

We present empirical evidence that household inflation disagreement weakens the power of forward guidance and conventional monetary policy shocks. The attenuation effect is stronger when inflation forecasts are positively skewed and it is not driven by endogenous responses of inflation disagreement to contemporaneous shocks. These empirical observations can be rationalized by a model featuring heterogeneous beliefs about the central banks' inflation target. An agent who perceives higher future inflation also perceives a lower real interest rate and thus borrows more to finance consumption, subject to borrowing constraints. Higher inflation disagreement would lead to a larger share of borrowing-constrained agents, resulting in more sluggish responses of aggregate consumption to changes in current and expected future interest rates. This mechanism also provides a microeconomic foundation for Euler equation discounting that helps resolve the forward guidance puzzle.
Original languageEnglish
Place of PublicationWashington, D.C.
PublisherBoard of Governors of the Federal Reserve System
Pages1-63
Number of pages63
DOIs
Publication statusPublished - 4 Dec 2024

Publication series

NameFinance and Economics Discussion Series
No.2024-094
ISSN (Print)1936-2854
ISSN (Electronic)2767-3898

User-Defined Keywords

  • Inflation disagreement
  • Inflation expectations
  • Heterogeneous beliefs
  • Borrowing constraints
  • Monetary policy transmission
  • Forward guidance puzzle

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