The Memory of Inflation
Almost every economic decision depends on expectations, especially long-term ones. Expectations shape how households borrow, how firms invest, how governments issue debt, and how markets set interest rates. When a household takes out a mortgage, for example, it is not only thinking about today’s income and today’s prices. It is also making a bet on future inflation, future income, and future interest rates.
Forecasts Tend to Overestimate Future Inflation
In a recent paper, my coauthors and I study inflation forecasts made by banks in 18 advanced economies between 1989 and 2022. We document a striking result: when expected inflation is high today, forecasters tend to overreact and overestimate future inflation. This mistake is small in the short run, but much larger at longer horizons, especially five to ten years ahead. When inflation rises, forecasters often behave as if it will remain high for a long time.
Forecast errors can always occur. Wars, energy shocks, and financial crises are hard to predict. The errors we document, however, are different. They are systematic: they are not random mistakes that simply average out, but reflect predictable biases that, at least in principle, could have been avoided.
The Weight of Memory on Expectations
Why does this happen? Our research suggests that memory plays an important role. When current inflation is high, forecasters are more likely to recall past episodes of high inflation. Memories of inflation become more “salient” and receive more weight in forecasts. A country’s inflation history matters for how people imagine its future. If a country experienced high and volatile inflation in the past, a new inflation spike may lead forecasters to expect it to stay high for too long.
These biased expectations do not remain confined to forecasts. They enter market prices. Nominal interest rates depend partly on expected inflation: if investors believe inflation will remain high for several years, they will demand higher nominal rates, especially on long-term bonds and loans. But if inflation expectations overreact to current news, so will interest rates. High inflation today can lead borrowers and lenders to agree on high rates, only for inflation to turn out lower than expected later on.
When Estimation Errors Redistribute Wealth
Forecast errors redistribute wealth. Consider a household taking out a fixed-rate mortgage when markets expect high long-term inflation. If inflation later turns out to be lower than expected, the household’s repayments become heavier in real terms. The same logic applies to indebted firms and governments issuing nominal debt. The bond issuer loses; debt buyers gain.
This redistribution also matters for the wider economy. Borrowers, such as households with mortgages or firms financing investment, often spend more of their income than lenders. If their real debt burden rises, they may cut consumption or investment. Lenders may not increase spending by the same amount. The result can be weaker demand and lower output. If high inflation expectations emerge during booms, the correction may arrive later and make downturns worse.
Lessons for Policymakers
Our research yields an important lesson for policymakers. Inflation is costly not only because prices rise today, but also because high inflation can become part of a country’s collective memory. If households and investors live through a long period of high inflation, that experience may shape expectations for years. Even after inflation falls, people may continue to fear that it will return. This can keep long-term inflation expectations too high and push up market interest rates. For this reason, policymakers must act quickly when inflation rises. The goal is not only to bring current inflation down, but also to prevent a high-inflation episode from becoming a lasting reference point in people’s minds. A short inflation shock is painful; a long inflation memory can be even more damaging.
