Inflation Expectations in Latvia: Consumer Survey Based Results

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Inflation Expectations in Latvia Consumer Survey
Based Results

• Konstantins Benkovskis
• Bank of Latvia

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Goals of the research

• Review data on consumer surveys.
• Quantify inflation expectations in Latvia, using
  data on consumer surveys.
• Find out the relation between Latvia's inflation
  and inflation expectations.

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Consumer survey in Latvia

• Surveyed on a monthly basis since May 2001.
• Sample size 1000 respondents.
• Questions assessing changes in the economic
  situation in Latvia in the past 12 months, and
  predictions for the next 12 months.
• The results are published on the web site of
  European Commission in balances.

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Consumer survey questionsPerceived inflation

• Question 5 How do you think that consumer prices
  have developed over the last 12 months? They have
  
• risen a lot ( )
• risen moderately ()
• risen slightly ()
• stayed about the same ()
• fallen ( )
• dont know
• --------------------------------------------------
  ----
• Balance (a) 0.5(b) 0.5(d) (e)

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Consumer survey questionsExpected inflation

• Question 6 By comparison with the past 12
  months, how do you expect that consumer prices
  will develop in the next 12 months? They will
• increase more rapidly ( )
• increase at the same rate ()
• increase at a slower rate ()
• stay about the same ()
• fall ( )
• dont know
• --------------------------------------------------
  ----
• Balance (a) 0.5(b) 0.5(d) (e)

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Actual, perceived and expected inflationConsumer
survey data
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How good perceived inflation match actual
inflation?
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Detailed survey dataPerceived inflation
responses to Question 5
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Detailed survey dataExpected inflation
responses to Question 6
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Problems stemming from direct use of consumer
survey data

• Formulation of Question 6 implies a comparison
  with the current situation. Hence, the magnitude
  of inflation expectations is expressed also in
  the perception of the current situation.
• Survey data are difficult to interpret
  economically, as they are not directly comparable
  with the actual inflation.

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Quantification of inflation expectationsCarlson-
Parkin methodology

• Aggregate distribution of expected inflation in
  the coming 12 months.
• Quantification is an exercise in recovering the
  mean of the aggregate distribution ?expt.
• The shares of responses in each survey category
  are interpreted as maximum likelihood estimates
  of areas under aggregate density function of
  inflation expectations.

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Quantification of inflation expectationsCarlson-
Parkin methodology
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Quantification of inflation expectations
Carlson-Parkin methodology
F(Z1t) share of answers (b) to (e) on Question
6 F(Z2t) share of answers (c) to (e) on
Question 6 F(Z3t) share of answers (d) to (e)
on Question 6 F(Z4t) share of answer (e) on
Question 6
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Quantification of inflation expectations
Carlson-Parkin methodology

• Quantification results depend on assumptions
  about the perceived inflation
• respondents correctly perceive inflation and
  published inflation can be used to scale
  expectations series.
• the level of perceived inflation is quantified
  from the answers on Question 5, using
  Carlson-Parkin methodology.

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Quantified inflation expectationsPerceived
inflation equals to inflation rate
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Quantified inflation expectationsPerceived
inflation quantified by C-P methodology
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Expectations and inflationsmall VAR model

• VAR model variables
• endogenous variables
• pt HICP annual inflation
• pexpt inflation expectations (CP methodology)
• yt output gap
• exogenous variables
• unprocessed food prices
• oil prices
• EU25 HICP
• nominal effective exchange rate
• dummy variable (changes in administratively
  regulated prices and taxes).

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Expectations and inflationimpulse response
functions
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Expectations and inflationVAR model results

• According to the VAR model results
• Inflation has positive and statistically
  significant reaction to the expectations shock.
• Inflation expectations have positive and
  statistically significant reaction to inflation
  and output gap shocks.
• There is an inertia in inflation expectations.

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Inflation expectations shocks
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Contribution of expectations shocks to actual
inflation
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Conclusions

• Inflation expectations shocks statistically
  significantly affect Latvia's inflation.
• Inflation expectations increased notably before
  the accession to the EU
• The rise was mainly determined by exogenous
  factors increase in administratively regulated
  prices, depreciation of the lat, growth of
  unprocessed food prices.
• Expectations shocks also increased, reflecting
  the negative campaign in mass media and
  scepticism of respondents.
• The contribution of expectations shocks to
  inflation is rather small (0.4-0.5 points prior
  to the accession, 0.2-0.3 points at the end of
  2006).
• Inflation expectations inertia will hurdle the
  immediate fall in actual inflation.