LearnInCycle · A Learning-from-Prices view of Inflation and Business Cycles

The Eurozone is currently facing a sudden and sharp increase in inflation. Whether inflationary pressures will persist and what will be the cost of an eventual monetary tightening crucially depends on inflation expectations. The aim of this project is to provide theoretical and empirical support to a new channel, through which inflation may persistently shift business activity. The project sheds new light on how market prices influence consumers perceived inflation and how this may allow for the transmission of monetary policy even in the absence of rigidities in firms pricing. It shifts the focus from a traditional firm-centric to a (complementary) household-centric view of money non-neutrality. It shares the spirit of a recent trend in central banks efforts in getting a better appraisal of the importance of consumers expectations, after decades of a strict empirical focus on firms pricing. The project consists of five working packages (WP) based on the idea that households inflation perceptions, driven by actual market prices, can be a major source of the business cycle. The first WP proposes a new theory where output-inflation co-movement relies on consumers price hunting in response to perceived inflation, causing a counter-cyclical gap between posted and paid prices inflation. The second and third WP aim at validating the mechanism using large datasets on consumers spending and retail trade. The fourth presents a new model where consumers learn from inflation about future economic prospects on which all have dispersed foresight. The fifth will estimate this model on survey data. The key novelty of the project is studying, not only how expectations move market outcomes, as typical in the literature, but also how these feed-back to expectations through prices in a full circle of general equilibrium implications. As by-product, it identifies measurable empirical counterparts for incomplete information sets.