Charles River Associates

This paper argues that individuals may rationally weight price increases for food and energy products differently from their expenditure shares when forming expectations about price inflation. If food and energy price inflation exhibits a sufficient degree of persistence and wage adjustment is not too sluggish, we show that it is rational to put more weight on inflation in these sectors than their expenditure shares in the Consumer Price Index would warrant. We develop a simple dynamic model of the economy in which individuals are partly backward looking to illustrate this finding. We then test the prediction of the model using data on expected inflation from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. Our results show that the weights implied by the model for constructing expectations of inflation differ from the expenditure weights of food and energy prices in the Consumer Price Index for the United States. In particular, we find that food price inflation is weighted more heavily and energy price inflation is weighted less heavily. But importantly, we cannot reject the hypothesis that these weights reflect rational behavior in forming expectations about inflation. Our analysis validates concerns sometimes raised by policymakers as to whether expectations might not be well anchored with respect to commodity price shocks. As a consequence, policy may need to be calibrated carefully to prevent such shocks from becoming embedded in expected inflation