Real effects of inflation expectation uncertainty

Abstract Using survey data on consumer expectations, we find that a rise in inflation expectation uncertainty lowers both current and expected consumption spending. The relationship holds after controlling for income, financial conditions, demographics, the level of expected inflation, and five widely used measures of aggregate uncertainty. To rationalize this result, we incorporate uncertainty about how the household cognitively discounts its future inflation expectations into an otherwise standard New-Keynesian model. Unlike in previous work, the degree of cognitive discounting is itself time-varying and subject to an uncertainty shock that widens its distribution. Estimating the model by simulated method of moments yields a steady-state cognitive discount factor of 0.752, implying an information half-life of roughly two and a half quarters. Combined with precautionary saving motives, the increases in markup and expected real interest rate arising from inflation expectation distortion amplify the fall in consumption.