Inflation Disagreement Weakens the Power of Monetary Policy

Dong, Ding; Liu, Zheng; Wang, Pengfei; Wei, Min

doi:10.17016/FEDS.2024.094

Working Paper

Inflation Disagreement Weakens the Power of Monetary Policy

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.

Keywords: Inflation disagreement; Inflation expectations; Heterogeneous beliefs; Borrowing constraints; Monetary policy transmission; Forward guidance puzzle;

JEL Classification: E21; E31; E52; E71;

https://doi.org/10.17016/FEDS.2024.094