When higher inflation expectations spur growth — and when they don’t

Managing inflation expectations has become a central plank of modern monetary policy. A growing body of theory argues that convincing households to expect higher inflation can reduce real interest rates and encourage spending when nominal policy rates are at or near zero. Recent work by Stefano Fasani and Lorenza Rossi, and complementary empirical studies, show that this channel operates only under specific conditions: chiefly, when households are not highly uncertain about the future path of prices.

The textbook channel: expectations, real rates and spending

The mechanism by which higher expected inflation can boost activity is straightforward in macroeconomic models. What matters for consumption and borrowing decisions is the real interest rate—the nominal rate adjusted for expected inflation. If nominal borrowing costs are fixed and expected inflation rises, the real cost of credit falls, making durable purchases and investment more attractive.

This logic was prominent in policy discussions after the global financial crisis, when many central banks hit the zero lower bound (ZLB) and could not lower policy rates further. Work by prominent macroeconomists suggested that shifting expectations could substitute for conventional easing: higher expected inflation reduces ex ante real rates and supports demand even when the policy rate is stuck at or near zero.

The survey puzzle: why households often cut spending

Empirical work using household-level surveys has yielded results that appear to contradict this mechanism. Several studies find that individuals who report higher expected inflation tend to be more pessimistic about the economy, anticipate weaker labour-market outcomes and reduce spending on durables.

Researchers attribute this pattern to differences in information and experience between households and professional forecasters. Households often form inflation expectations from the price changes they encounter most frequently—food, fuel, energy bills and rents—items that respond strongly to supply shocks and geopolitical events. When these familiar prices spike, households may read higher inflation as a direct signal of economic deterioration rather than as an incentive to borrow and spend. The result is greater precautionary saving and postponed consumption.

Reconciling theory and surveys: the role of regime and uncertainty

Recent analysis reconciles the two strands of evidence by distinguishing monetary regimes and introducing inflation uncertainty as a key channel. Fasani and Rossi develop a model and present empirical estimates for the United States covering several decades. Their results show a clear state-dependent response:

• In normal monetary conditions, increases in household inflation expectations tend to coincide with weaker activity and rising unemployment. Households interpret expected inflation as a signal of adverse shocks, prompting precautionary responses.
• At the zero lower bound, by contrast, higher expected inflation lowers ex ante real rates without an immediate policy-rate offset and is associated with stronger consumption and falling unemployment.

These regime-differentiated effects align the theoretical prediction that higher expected inflation can be expansionary when nominal rates cannot fall further with the survey evidence that, in many episodes, higher expectations are associated with contraction.

However, the reconciliation is incomplete without accounting for inflation uncertainty. The authors and related empirical work show that when expected inflation is accompanied by greater dispersion and uncertainty among households, precautionary saving increases and the purported stimulus from lower real rates is substantially weakened — and can even be reversed. In other words, the same average expectation can have markedly different macroeconomic consequences depending on how confident people are about that forecast.

"Managing inflation expectations is only part of today’s challenge for monetary policy-makers. In times of geopolitical tensions and repeated economic shocks, they must also ensure that their communications with households and financial markets keep uncertainty about future inflation under control," Fasani and Rossi wrote.

Labour-market evidence and empirical strategy

The literature uses unemployment responses as a summary indicator of cyclical effects. Empirical estimates comparing the response of unemployment to increases in household inflation expectations show opposite signs across regimes: unemployment tends to rise in normal times but falls at the ZLB. When inflation uncertainty is elevated, even at the ZLB the net effect can be contractionary.

These findings rely on long-run quarterly samples and household survey measures of both expected inflation and inflation uncertainty (for example, indices capturing the dispersion of responses). The results are robust to standard inference procedures and align with theoretical predictions that incorporate precautionary motives.

Implications for central banks and open questions

The policy implications are twofold. First, central banks need to continue anchoring average inflation expectations around the target to preserve credibility and avoid destabilising behaviour. Second, and critically, communication strategies should aim to reduce unnecessary uncertainty and disagreement about future inflation.

Periods of heightened uncertainty—such as the COVID-19 pandemic, energy shocks, or episodes of geopolitical instability—inflate the dispersion of household expectations. In such environments, attempts to stimulate demand by encouraging higher expected inflation are likely to be less effective and could backfire if they increase perceived economic risk.

Important questions remain. Economists still lack a detailed understanding of how different segments of the population form expectations and how policymakers can credibly reduce uncertainty without sacrificing flexibility to respond to shocks. More granular data on expectation formation and experimental evidence on communication strategies would help refine policy prescriptions.

For now, the research suggests a simple but nuanced message for policymakers: raising inflation expectations can be an effective tool only under particular monetary conditions and only if it does not increase uncertainty among households. Where uncertainty is high, the precautionary savings response may dominate, undermining the intended stimulus.

Looking ahead

As central banks navigate a world characterised by intermittent shocks and geopolitical risk, their communications will become ever more important. The balance they must strike is delicate: shape expectations to support macroeconomic objectives while doing so in a manner that preserves public confidence and limits dispersion. Future research that sheds light on how different communication formats affect both mean expectations and uncertainty will be essential for those decisions.