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Inflation – who cares? Monetary Policy in Times of Low Attention

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The decrease in the volatility and persistence of US inflation was accompanied by a decline in the public’s attention to inflation. But has the public always been so inattentive to inflation? And what do these low levels of attention imply for monetary policy? Oliver Pfauti seeks to answer these questions.

Image courtesy of interviewee. November 30, 2023

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This video video discusses the role of inflation expectations in monetary policy, particularly when a central bank is constrained by a zero lower bound on nominal interest rates. It explains that central banks can manage these expectations by committing to keep rates low for extended periods, which could lead to overheating and higher future inflation. This video video mechanism helps to lower real interest rates, encouraging consumption and investment, and can mitigate declines in economic activity.

However, the author points out that public inattention to inflation can hinder the effectiveness of these policies, leading to what is termed an "inflation attention trap." In such scenarios, the economy may remain stagnant at the zero lower bound due to insufficient public responsiveness to the central bank’s forward guidance.

The paper presents two principal contributions: first, it empirically examines how public attention to inflation has evolved over the past 50 years, finding that attention increases during periods of high inflation. Second, it derives the optimal monetary policy under these conditions, emphasizing that accounting for the zero lower bound is crucial. The findings suggest that while low attention may stabilize inflation in normal times, it can become detrimental when the lower bound restricts policy options.

In essence, the paper argues that understanding changes in public attention to inflation is vital for developing effective monetary policies, especially during times of economic uncertainty and fluctuating inflation levels. Recent inflation trends post-pandemic have drawn renewed attention to these dynamics.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

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So, in most monetary policy models,

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managing inflation expectations is a very powerful tool

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for monetary policy.

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And this becomes especially relevant at the zero

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or the effective lower bound constraint.

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So let's say that a central bank's main instrument,

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that short term nominal interest rate

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is stuck at the zero lower bound

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and it cannot go further down.

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Now in theory, what the central bank could do is they could

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promise to stay at the lower bound for longer than they have

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to, which then basically means

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that the central bank promises

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that they would let the economy overheat a little bit in the

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future and we would expect the future

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economic boom and higher inflation.

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Now this should then increase people's expectations about

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future inflation already today.

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And because of these high inflation expectations,

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the real interest rates,

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so the nominal rate minus inflation expectations decreases

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and therefore households do not want to save as much

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and they would rather consume more.

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And because of the higher inflation expectations,

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firms will want to set higher prices.

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So now even though the central bank may not be able

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to move the nominal rate further down

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because of the lower bound,

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they can decrease the real interest rate.

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And through this we should then see only a relatively mild

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decrease in economic activity

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and in inflation, even though the economy

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is at the lower bound.

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In practice this might be a bit different

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because the general public in most advanced economies at the

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time when the lower bound was binding, was very inattentive

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and poorly informed when it comes

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to monetary policy and inflation.

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And at the same time, we also saw

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that many central banks were struggling

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to bring inflation up to their inflation targets.

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So in this paper what I ask basically is the question

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whether these two observations may be related

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and it turns out that they are.

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So, as I will explain a little bit in more detail later on,

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I find that when people do not pay a lot of attention

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to inflation, the economy can get stuck in

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what I call an inflation attention trap.

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So these are long periods in which the economy gets stuck at

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the zero lower bound because people are inattentive and

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therefore these promises

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or forward guidance policies

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that the central bank makes are not very effective in

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stimulating people's expectations.

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So this is why then the economy may get

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stuck at the lower bound.

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And I show that this actually matters quite a bit

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for optimal monetary policy.

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And I find that accounting for the lower bound is,

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is crucial for these, for the normative implications.

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So if you do not account

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for the zero lower bound constraint,

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then lower attention is actually welfare improving.

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But that completely changes once we account

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for the lower bank because then the economy may run into

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these attention traps.

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And to prevent this from happening,

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the central bank optimally induces a higher

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average inflation rate.

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But this is costly from a welfare perspective.

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So welfare is actually lower when attention is low.

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So there are two main contributions to the literature

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that I make in this paper.

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The first contribution is

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that I empirically quantify attention to inflation

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and in particular how attention has changed

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over the last 50 years.

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And I find that it changed a lot

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and that attention is higher in times of high

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and volatile inflation.

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The second main contribution that I make is

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that I derive the Ramsey optimal monetary policy when the

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central bank faces an occasionally binding lower bound

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on the nominal rate.

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And when private agents only pay limited

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attention to inflation.

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Earlier papers that studied the optimal monetary policy

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with limited attention did not take the lower bound

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constraint into account.

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But I find that accounting

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for this lower bound actually completely flips the normative

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implications of lower attention.

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In a first step, I propose a way

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how we can estimate people's attention

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to inflation using survey data.

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So this is based on a model

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where the agents decide optimally

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how attentive they want to be.

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If they are more attentive,

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they make smaller forecast errors.

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But being attentive is also costly

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because then you have to acquire

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and process information that takes time and mental effort.

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So what then comes out of this model is

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that attention can basically be measured by

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how strongly agents update their inflation expectations when

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they make a forecast error.

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And the model also predicts

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that attention should be higher when inflation is volatile

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or when it is persistent.

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So then to estimate attention, I use several surveys

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that ask people about their inflation expectations.

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I use data on professional forecasters.

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I use data on households.

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And in this study I focus on the United States going back

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all the way to the late, late 1960s.

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And this long time span actually allows me

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to test whether people's attention

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to inflation has changed over time or not.

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And I can examine when is attention high and when is it low.

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And then later in order to understand the implications

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of the empirical findings for monetary policy,

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I developed a new casin model where I introduced this idea

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of limited attention to inflation

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and I imposed that the center bank is potentially

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constrained by a zero lower bound on nominal interest rates.

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So what I find in the data is that people's attention

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to inflation before the covid 19 pandemic was actually at a

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historical low, but attention has not always been that low,

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but it changed actually quite a bit over time.

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So in the seventies and eighties when inflation was high

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and volatile and persistent,

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people were much more attentive to inflation.

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And this is in line with what the underlying model

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of attention that I have in the

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background actually predicts.

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So then given these findings,

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I turn to the optimal policy problem

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and I show that there's a trade-off of lower attention

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for monetary policy.

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On the one hand, when attention is low,

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inflation expectations respond less to new information.

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So inflation expectations become more stable,

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which then also helps to stabilize actual inflation.

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And this is welfare improving.

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On the other hand, it becomes difficult

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to affect people's expectations when they're not attentive.

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And this becomes an issue at the zero lower bound

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because then monetary policy cannot use their usual

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instrument than nominal rate,

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but they rather have to steer people's inflation

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expectations by making promises about the future path

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of the nominal rate.

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But when people are not attentive,

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these promises are not very effective

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and the economy may then run into these so-called inflation

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attention traps, where you get stuck at the zero lower bound

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for much longer because people are not listening to

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what the central bank is telling them, and

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therefore the central bank cannot manage their expectations.

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Now, in terms of the implications

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for optimal monetary policy, what I find is

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that at accounting for the lower bound completely

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changes the picture.

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So if we do not account for the zero lower bound,

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then lower attention stabilizes inflation.

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This is welfare improving.

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However, once you do account for the lower bound,

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this now changes because now you have

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to avoid these attention traps from happening,

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which you can achieve

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by inducing a higher average inflation rate.

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But be because with a higher inflation rate,

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what you have is that the nominal rate on average is also

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higher and therefore further away from the lower bound so

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that the lower bound becomes less likely to bind.

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However, this then means that you have to allow, allow

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for this higher inflation rate on average,

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and this is costly from a welfare perspective.

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So the lower people's attention

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to inflation is the larger is this increase in the optimal

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inflation rate, and therefore the largest

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is the welfare loss.

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So if you do account for the lower bound welfare

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decreases when attention decreases,

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whereas if you do not account

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for the lower bound welfare actually increases when

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attention decreases.

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Overall in this paper, what I show is

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that people's attention to inflation changes over time,

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and it depends on the economic environment.

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And this actually turns out to matter quite a bit

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for monetary policy.

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So the decrease in people's attention to inflation

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after the So-called great inflation period in the seventies

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and eighties was probably desirable at first

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for monetary policy

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because this helped to stabilize inflation expectations

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and then ultimately actual inflation as well.

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However, the paper highlights

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that people's low attention may actually become a challenge

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or an issue for monetary policy

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once the zero lower bound constraint may be become binding.

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Now with the recent surge in inflation

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after the pandemic, people

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Actually started again to become

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more attentive to inflation.

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As I show in a more recent paper,

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which is titled the Inflation Attention Threshold

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and Inflation Surge.

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And I show that this increase in attention may AC actually

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help us to understand some

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of the recent inflation surge we have seen.

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So again, this highlights the importance

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that people's attention to inflation may change

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and policy in particular monetary policy may want to take

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that into account when thinking about the appropriate

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policies in different economic environments.

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