Inflation Disagreement Weakens the Power of Monetary Policy

"Household inflation disagreement weakens the impact of forward guidance and monetary policy shocks, especially when inflation forecasts are positively skewed. This attenuation effect is not driven by endogenous responses of inflation disagreement to contemporaneous shocks. A model with heterogeneous beliefs about the central bank’s inflation target explains these observations. Agents expecting higher future inflation perceive lower real interest rates and borrow more, constrained by borrowing limits. Increased inflation disagreement results in more borrowing-constrained agents, leading to slower aggregate consumption responses to interest rate changes. This mechanism also provides a microeconomic foundation for Euler equation discounting, helping to resolve the forward guidance puzzle.