Inflation expectations and the sacrifice ratio

Using inflation forecasts from the The Organisation for Economic Co-operation and Development (OECD)'s Economic Outlook as proxy measures of inflation expectations, we examine the impact of inflation expectations on the sacrifice ratio for 20 OECD countries. The regression analysis considers five different empirical models of the determinants of the sacrifice ratio typically found in the existing literature. The first set of regressions considers the impact of the level of inflation expectations prevailing at the beginning of a disinflationary episode. The direct impact (or the total impact in models with interaction terms) of the level of inflation expectations is negative and significant in all five models, implying that a higher level of expected inflation is associated with a lower sacrifice ratio. This result is consistent with the theoretical role of nominal price and wage rigidities in that reductions in wage and price stickiness diminish the tradeoffs between disinflations and output losses. Interaction effects indicate that higher levels of expected inflation, consistent with reduced wage and price stickiness, allow policymakers to pursue “cold turkey” inflation reductions even more aggressively. A second set of regression models examine the role of changes in inflation expectations that occur over a disinflationary episode rather than the level of inflation expectations. Consistent with the results for the level of expectations, the effect of the change in inflation expectations is negative and significant in all five regression models, implying that faster adjusting inflation expectations are associated with lower sacrifice ratios. Likewise, the interaction between changes in inflation expectations and the length of the disinflation is negative and significant, indicating that faster adjusting expectations allow policymakers to pursue disinflations even more quickly.