Measuring inflation expectations: How stable are density forecasts?

A common assumption of economic models is that inflation expectations matter for firms’ and households’ decisions. Central banks are interested in measuring these expectations to monitor the effectiveness of their monetary policy and to plan future interventions. Inflation expectations are commonly measured by conducting surveys on representative samples of a population. In the past, many of these surveys asked respondents either for a point prediction of the future inflation rate (that is to state a specific number), or to pick an interval out of multiple offered. More recently, central banks have started using density forecasts.

In a density forecast, survey respondents are shown a number of intervals representing possible ranges of future inflation rate (e.g. 0% to 1% might be one such an interval, 1% to 2% the next). We refer to the totality of these intervals as the scale of the density forecast. In several density forecasts, such as that of the New York Fed SCE (survey of consumer expectations), the scale is centered on a salient value, such as zero and covers both possibilities, inflation and deflation rates. Respondents are then asked to state for each interval a probability that reflects how likely they think it is that the inflation rate will fall within this interval in the future. Compared to point forecasts (which ask for a single number) or to questions asking to pick a single interval, density forecast provide much more fine-grained information about a respondents’ inflation expectations. Specifically, this approach allows to quantify the uncertainty respondents have in their expectations and to better study the disagreement between differing expectations.

Density forecasts have become increasingly common, with institutions such as such as the New York Fed or the German Bundesbank using them. In the future, we expect density forecast to become a ubiquitous tool in inflation expectations research. Like every other survey measure, data obtained from density forecasts can be misleading if the survey questions are not designed and interpreted carefully. Past research has shown that the scales on which a question is asked affect the answers given by respondents. Due to that, particular care must be taken in how the scale is constructed and how meticulous it is used in subsequent versions of the survey.

Our research project provides a thorough test of the consistency of expectations stated in density forecasts with regards to the scale used. We use the inflation expectation question utilized by the NY Fed in the SCE and the Bundesbank as a baseline, which allows our results to provide meaningful results about currently used methods by policy-relevant institutions. Based on the question, we test how the answers are affected by changes to the scale.