Inflation Expectations with Finite Horizon Planning

Gust, Christopher J.; Herbst, Edward P.; López-Salido, J. David

doi:10.17016/FEDS.2024.063

Working Paper

Inflation Expectations with Finite Horizon Planning

Abstract: Under finite horizon planning, households and firms evaluate a full set of state-contingent paths along which the economy might evolve out to a finite horizon but have limited ability to process events beyond that horizon. We show--analytically and empirically--that such a model accounts for an initial underreaction and subsequent overreaction of inflation forecasts. A planning horizon of four quarters can account for the evidence on the predictability of inflation forecast errors and macroeconomic data. Our identification and estimation strategies combine full-information methods based on aggregate data with regression-based estimates that directly use inflation expectations data.

Keywords: Finite horizon planning; Inflation expectations; Bayesian estimation;

JEL Classification: C11; E52; E70;

https://doi.org/10.17016/FEDS.2024.063