Inflation Expectations and Gasoline Prices

Abstract

Empirically, changes in gasoline prices have very little predictive value for future realized inflation. However, gasoline price changes are strongly predictive of household expectations of future inflation. This paper first establishes this fact empirically, then develops and estimates a model showing that this incorrect interpretation by households is due to an an extrapolative bias in which recent observed changes are thought to have a much larger weight on future outcomes than they should. As household inflation expectations are an important input into monetary policy decisions, understanding this link could provide useful information to policy makers.

Keywords: inflation expectations, gasoline prices, extrapolative bias, behavioral economics

JEL Classification: E70, E31, D10