Irrational Inflation Phobia and Unemployment in the USA

Inflation forecasts in the Livingston survey of experts are systematically different from inflation and thus do not correspond to the hypothesis of rational expectations and a quadratic loss function. One striking feature of the forecast errors is that the averages over decades of the median over participants forecast error are dramatically different from zero and from each other. The median forecasts were systematically lower than inflation in the 50s and 60s and higher than inflation in the 80s and 90s. The result for the 80s is particular dramatic. The average median forecast was slightly more than 2% greater than the actual inflation. This is irrational inflation phobia if rational is defined to mean rational expectations and reporting the subjective mean (as would be optimal if the forecaster were attempting to minimize a quadratic loss function) and phobia is defined to mean high expected inflation (not say a high estimate of the social costs of inflation). People were invited to participate in the Livinston survey because they were perceived to be experts, so it is reasonably likely that policy makers made similar forecast errors. Thus it is very possible that the inflation phobia of the 80s and 90s caused high estimates of the non accelerating inflation rate of unemployment (NAIRU) and therefore high target unemployment. In fact, inflation phobia is statistically significantly correlated with unemployment. This is most dramatically shown by a scatter of decade averages.


The 1970s are the only exception to the rule that higher overestimates of future inflation correspond to higher unemployment. It seems that in this case, as in so many, for macro-economists it is always the 1970s, so the extremely obvious pattern has not been noticed.

A simple regression (with heteroskedastic robust standard errors) suggests that a 1% increase in the overestimate of the next 6 months’ annualized CPI inflation corresponds to a one third of one percent increase in the unemployment rate.


The Boring details

The data on forecasts are taken from the Livingston web site . Starting in 1946 each June and December, participants forecast economic variables including the consumer price index 6 months and 12 months after the date of the survey.

Here I use the median forecast of the consumer price index 6 months after the date of the survey. The forecast inflation rate (finf6) is the square of the ratio of that forecast and the price level in the base period (provided by Livingston) minus one. That is it is the forecast of the annualized rate of inflation over the next six months. Calculating corresponding achieved inflation is not completely trivial. The Livingston survey asked for the CPI index but changing the base year from time to time and not exactly when the BLS changed the base year. A standard time series of the CPI will have one unchanging base year and deviate from the value survey participants were attempting to forecast. Fpr the inflation outcome (inf6) I use the annualized rate of increase of the base period CPI from one wave of the survey to the next unless the base year was changed (giving rates of ,for example, around -50%). For those intervals I used the annualized rate of increase from June to December (or from the previous December to June) of the CPI index from FRED . This is not ideal because the base year for the FRED data is 2009 but it only affects the measurement of inflation for three intervals: from June 1953 to December 1953, from December 1961 to June 1962, from December 1970 to June 1971, and from December 1987 to June 1988. In the 1940s inflation was very hard to forecast (the study started almost exactly when WWII price controls were eliminated). It is also possible that the Livingston team re-evaluated who they considered to be an expert after the terrible performance of their panel in the first few years. In any case, I generally use data only from the 1950 on. The survey was redesigned in 2003, so I don’t use data from more recent years.

The unemployment rate is the standard headline unemployment rate (U3) from Fred.