The Macroeconomic Effects of Inflation Expectations: The Distribution Matters

We augment a parsimonious monetary policy Bayesian VAR with heterogeneous expectations from the Michigan Survey to investigate the macroeconomic effects of shocks to the distribution of short term inflation expectations. A first surprising result is that (the Michigan survey) inflation expectations do not seem to be much influenced by macroeconomic developments, while the opposite is not true. Moreover, a comprehensive density impulse response function analysis shows that it matters to take into account the whole expectation distribution. First, it matters because considering only the first and second moment of the distribution leads to an underestimation of the macroeconomic effects of expectations shocks. Second, mean and variance shocks are stagflationary, while dispersion shocks might be recessionary. Third, the effects are sharper when the shock mass is condensed on the tails. Specifically, left-tail perturbations account for the largest effect of expectations shocks on macroeconomic fluctuations. It follows that central bank communication should focus on the tails: reducing the noise/dispersion might be more effective than anchoring the mean.