Can higher inflation expectations ever stimulate the economy?

Managing inflation expectations is only part of today’s challenge for monetary policy-makers. In times of geopolitical tensions and repeated economic shocks, they must also ensure that their communications with households and financial markets keep uncertainty about future inflation under control.

Households’ expectations about future inflation play a central role in modern monetary policy. They influence how much households choose to spend or save – and ultimately, how effectively central banks can stabilise the economy.

Since the global financial crisis of 2007-09, economists have argued that raising inflation expectations can stimulate demand when interest rates are close to zero by lowering real borrowing costs. Yet evidence from household surveys appears to tell a different story: households expecting higher inflation often become more pessimistic about the economy and reduce, rather than increase, their spending.

Drawing on recent research, this article shows that these seemingly conflicting findings can be reconciled. Higher inflation expectations can stimulate spending when interest rates are constrained by the zero lower bound, but this expansionary effect depends critically on uncertainty about future inflation.

When uncertainty rises, precautionary saving (households saving for a rainy day) goes up, thereby weakening – and potentially even offsetting – the stimulus from lower real interest rates. The findings highlight the importance of central banks not only shaping inflation expectations but also keeping uncertainty about future inflation under control.

Why can higher inflation expectations stimulate the economy?

The intuition is straightforward. What matters for households’ spending decisions is not simply the interest rate charged by banks, but the real interest rate – the nominal interest rate adjusted for expected inflation.

Suppose a household can borrow at a fixed interest rate of 3%. If inflation is expected to be 1%, the real cost of borrowing is around 2%. But if expected inflation rises to 3% while the nominal interest rate remains unchanged, the real cost falls to zero. Borrowing becomes cheaper in real terms, making it more attractive to buy a house, replace a car or undertake other major purchases today rather than postponing them until the future.

This mechanism became particularly important after the global financial crisis. With policy interest rates already close to zero, central banks had little room to provide further stimulus through conventional cuts in interest rates.

Influencing households’ expectations about future inflation therefore became an additional policy tool. By convincing households that prices would rise more rapidly in the future, central banks could reduce real borrowing costs and encourage spending, supporting output and employment (Krugman, 1998; Eggertsson et al, 2003; Werning, 2011).

Recent survey evidence tells a different story

While the theoretical mechanism is compelling, evidence from households has often painted a very different picture.

A growing number of studies using household surveys find that people who expect higher inflation tend to spend less, not more (Coibion and Gorodnichenko, 2015; D’Acunto et al, 2023; Bhandari et al, 2024). They also become more pessimistic about the broader economy and are more likely to expect unemployment to increase. Rather than bringing purchases forward, many postpone spending on durable goods such as cars, furniture and household appliances.

Professional forecasters build expectations using a wide range of economic data and formal forecasting models. Households, by contrast, often rely on the prices they observe most frequently in everyday life, such as food, petrol, energy bills or rent. These are also the prices most affected by supply disruptions and geopolitical events.

When these prices increase sharply, households may interpret higher inflation not simply as a fall in real borrowing costs, but as a signal that the economy is deteriorating. If they become worried about future income or job security, they are more likely to increase precautionary saving than to increase spending.

Higher inflation expectations may reflect pessimism about the economy rather than optimism about future demand.

The importance of the state of the economy

If higher inflation expectations lower real interest rates, why do households often spend less? The answer depends on the state of the economy.

When monetary policy is not constrained by the zero lower bound, increases in households’ inflation expectations often coincide with adverse economic developments, such as supply disruptions or rising energy prices. Households may interpret higher expected inflation as a signal that their future purchasing power and economic prospects are deteriorating. As a result, they become more pessimistic about future income and employment, postpone spending and increase precautionary saving. The overall effect on demand is therefore contractionary.

The picture changes when policy interest rates are constrained by the zero lower bound. Because nominal interest rates cannot be reduced further, higher inflation expectations lower real interest rates without triggering an offsetting increase in policy rates. Households now face stronger incentives to spend more, making higher inflation expectations expansionary rather than contractionary.

Our recent study (Fasani et al, 2026), which is forthcoming the Journal of Political Economy Macroeconomics, shows that the different findings in previous research can be reconciled once we distinguish between normal times and periods when monetary policy is constrained by the zero lower bound.

We analyse both a theoretical model and the empirical relationship between households’ inflation expectations and macroeconomic outcomes across these two monetary policy regimes.

The model predicts that an increase in households’ inflation expectations weakens economic activity in normal times, but it stimulates consumption and reduces unemployment at the zero lower bound by lowering real interest rates. Estimating the empirical relationship separately across the two regimes using data for the United States yields similar results, supporting the theoretical predictions.

But this is not the end of the story. Both the model and the empirical evidence show that inflation uncertainty plays a crucial role in shaping these effects. When households become sufficiently uncertain about future inflation, precautionary saving weakens – and may even reverse – the stimulus generated by lower real interest rates. This means that higher inflation expectations can become contractionary even at the zero lower bound.

Why is uncertainty the missing ingredient?

Even when interest rates are constrained by the zero lower bound, higher inflation expectations do not always stimulate the economy. The overlooked channel is households’ uncertainty about future inflation.

Imagine two households who both expect inflation to average 4% over the coming year. One is confident that inflation will remain close to that level. The other thinks inflation could end up anywhere between 1% and 8%. Although their average inflation expectations are identical, their behaviour is unlikely to be.

The more uncertain household is more likely to postpone discretionary spending and increase precautionary saving. Rather than taking advantage of lower real borrowing costs, it waits until the economic outlook becomes clearer.

We find that this precautionary saving motive substantially weakens the expansionary effects of higher inflation expectations when interest rates are constrained by the zero lower bound. As inflation uncertainty rises, households become increasingly reluctant to spend, and the stimulus generated by lower real interest rates becomes progressively smaller. When uncertainty is sufficiently high, it can almost disappear altogether.

Evidence from the labour market

Figure 1 illustrates these mechanisms using unemployment estimates as a summary indicator of the business cycle. A decline in unemployment reflects stronger economic activity, while an increase indicates a contraction.

Panel (a) compares the response of unemployment to an increase in households’ inflation expectations under two monetary policy regimes. In normal times (blue line), unemployment rises persistently. At the zero lower bound (red line), unemployment instead falls. The same increase in inflation expectations therefore has markedly different consequences depending on whether monetary policy is constrained.

Panel (b) shows how inflation uncertainty changes this result. When higher inflation expectations are accompanied by greater inflation uncertainty (measured using the household inflation uncertainty index developed by Binder, 2017), unemployment increases at the zero lower bound, whereas the effect is not statistically significant in normal times. This suggests that precautionary saving substantially weakens the expansionary effects of higher inflation expectations when interest rates are constrained by the zero lower bound.

Taken together, these findings reconcile two seemingly contradictory views of inflation expectations. Whether higher inflation expectations stimulate or depress economic activity depends not only on the monetary policy environment but also on how certain households are about the future path of inflation.

Figure 1. The effects of higher inflation expectations depend on the monetary policy regime and inflation uncertainty

Source: authors' calculations
Note. Panel (a) compares the response of unemployment to an increase in households' inflation expectations in normal times and when interest rates are constrained by the zero lower bound. Panel (b) shows how greater inflation uncertainty weakens the explanatory effects of higher inflation expectations at the zero lower bound. Shaded area denotes 68% confidence intervals based on Newey-West standard errors. Sample: 1983Q3-2024Q2.

What does this mean for central banks?

These findings have important implications for monetary policy.

Much of modern central banking focuses on keeping average inflation expectations anchored around the inflation target. Our findings suggest that this is only part of the challenge. Policymakers should also pay attention to the degree of disagreement and uncertainty surrounding those expectations.

Two economies may exhibit exactly the same average inflation expectations while displaying very different levels of inflation uncertainty. In one, households broadly agree about the future path of prices. In the other, expectations are widely dispersed because people are unsure how inflation will evolve. The average expectation is identical, but our research shows that the economic consequences may not be.

When inflation uncertainty is low, higher inflation expectations are more likely to reduce real borrowing costs and stimulate spending when interest rates are constrained by the zero lower bound. But when uncertainty is high – as in periods of economic crisis – households become more cautious and increase precautionary saving, weakening – or even offsetting – the stimulus generated by lower real interest rates.

The pandemic, supply-chain disruptions and subsequent energy price shocks all made the inflation outlook more uncertain. More recently, geopolitical tensions and trade disputes have continued to cloud expectations about future inflation.

In such an environment, central bank communication has a dual role. It should help households to understand where inflation is likely to settle over the medium term, but it should also reduce unnecessary uncertainty about the future path of prices. Policies that successfully influence inflation expectations while maintaining confidence in the inflation outlook are likely to be more effective.

What do we still need to learn?

Although economists have made considerable progress in understanding how households form inflation expectations, important questions remain. In particular, we still know relatively little about how inflation uncertainty shapes household decisions and how central banks can reduce unnecessary uncertainty while retaining the flexibility to respond to unexpected shocks.

As communication becomes an increasingly important monetary policy tool, future research should focus not only on how households form inflation expectations, but also on how confident they are in those expectations. Better understanding both dimensions will be essential for designing policies that effectively stabilise the economy.

Where can I find out more?

The perceived inflation wedge: why households experience inflation differently from official statistics: July 2026 VoxEU column by Neville Francis.
Mapping the household-level transmission of monetary policy: May 2026 VoxEU column by Olivier Coibion, Yuriy Gorodnichenko, Francesco Grigoli and Damiano Sandri
How does lower inflation uncertainty affect households’ financial behaviour? Piece by Christoph Herler and Philip Schnattinger on the Bank of England’s Bank Underground website.
Monetary Policy Report – July 2026: The Bank of England’s most recent economic analysis and inflation projections that the Monetary Policy Committee uses to make its interest rate decisions.