The Volatility of Inflation Expectations and Interest Rates

Abstract

We link the consensus inflation forecasts of major banks to interest rates in 18 advanced economies during 1989-2022. We detect horizon-increasing overreaction: high expected inflation today predicts inflation overestimation and higher real returns on nominal bonds, especially at long maturities. Thus, high expected inflation predicts a wealth redistribution from borrowers to lenders. We offer a learning model where investors overweight states that are salient in memory due to their past frequency or similarity to current inflation. The model endogenizes belief under- and overreaction based on features of the inflation DGP, accounting for cross-country variation in biases and return predictability.