Inflation in advanced economies typically increases by about 0.8 percentage points for each one-percentage-point increase in near-term expectations, while in emerging market economies, the increase does not exceed 0.4 percentage points.

Inflation reached its highest levels in decades last year worldwide. While overall inflation is steadily declining, core measures, which exclude food and energy, have proven to be more stable in many economies, and wage growth has rebounded.

Expectations about future inflation play a major role in driving inflation, as these views affect consumption and investment decisions that can impact today’s prices and wages. The best ways to inform people’s views on inflation have become more important as price increases have fueled fears that inflation may become entrenched.

In an analytical chapter from the latest World Economic Outlook report, we study how expectations affect inflation and the scope of monetary policy to influence these expectations to achieve a “soft landing,” a scenario in which the central bank guides inflation to its target without causing a deep decline in growth and employment. On the other hand; surveys show that near-term inflation expectations rose steadily in 2021 in both advanced and emerging economies, then accelerated as actual price increases gained momentum. However, five-year-ahead inflation expectations remained stable.

Recently, it seems that near-term inflation expectations have passed the turn and have begun to shift onto a gradual downward path. Away from the world of professional forecasters, we see similar patterns of inflation expectations from companies, individuals, and investors in financial markets on average. Our new statistical analysis shows that after the inflation shocks of 2021 and early 2022 began to recede, inflation was increasingly explained by near-term expectations.

For the average advanced economy, they now represent the main driver of inflation dynamics. For the average emerging market economy, the importance of expectations has increased, but past inflation remains more important, suggesting that people may be more backward-looking in these economies. This may partly reflect historically higher and more volatile inflation experiences in many of these economies.

Inflation in advanced economies typically increases by about 0.8 percentage points for each one-percentage-point increase in near-term expectations, while in emerging market economies, the increase does not exceed 0.4 percentage points.

This difference could be due to the proportion of backward-looking versus forward-looking learners across economic groups. Backward-looking learners form their views on future price changes based on their current or past experiences with inflation, especially when information related to inflation expectations is scarce and central bank communications are unclear or lack credibility. On the other hand, forward-looking learners form their expectations from a wide range of information relevant to future economic conditions, including central bank actions and communications.

These differences have significant implications for central banks. Policy tightening has less disinflationary impact on near-term inflation expectations and inflation when a larger share of people in the economy are backward-looking learners.

This is because these individuals do not fully understand that today’s interest rate increases will lead to slower inflation as they affect demand in the economy. Therefore, an increase in the share of backward-looking learners means that the central bank must tighten more to achieve the same decrease in inflation. In other words, reductions in inflation expectations and inflation come at a higher cost to output when there is a larger share of backward-looking learners.