I ask because inflation expectations have been more volatile than actual inflation. For example, since January 1985 the standard deviation of the five-year break-even inflation rate (at a monthly frequency) has been 1.78, while the standard deviation of actual annualised five-year inflation has been 1.46. A similar thing is true in the US. Since January 2003 - when data began - the monthly standard deviation of the five-year break-even inflation rate has been 0.63, while that of inflation has been just 0.39.
This tells us that it's not just shares that are more volatile than the 'fundamentals' (dividend growth) would warrant. Government bonds also display excess volatility. Why?
One possibility is that investors are overconfident. They overestimate their ability to foresee the future and so overreact to perceived news about future inflation, and underweight the extent to which inflation is either genuinely unpredictable or just doesn't change much from month to month. It's not just in gilts that this happens. Duke University's Craig Burnside says that overconfidence in inflation forecasts is one explanation for the forward premium puzzle, the tendency for high-yielding currencies to outperform low-yielding ones.
One fact is consistent with this hypothesis - that there's a strong negative correlation between the level of the five-year break-even inflation rate and subsequent annual changes in it. Since January 2003 this has been minus 0.73 in the UK and minus 0.63 in the US. A high break-even inflation rate leads to a falling rate, and a low one to a rising rate. This is consistent with investors overreacting to news about future inflation, and subsequently correcting their error.
There is, though, another explanation. Sometimes, investors attach a probability to scenarios which, though entirely possible, don't actually materialise. For example, in late 2008 they feared that economies could have sunk into a depression so deep as to cause prices to fall. This caused the break-even inflation rate to turn negative. As this fear diminished, break-even inflation rates rose, and so they seem to have been more volatile that actual inflation. But it doesn't follow at all that those fears were irrational.
The future consists of many possibilities while actual observed history comprises just one. When we compare expectations to out-turns, therefore, we are not comparing like with like.
There's a parallel here with the stock market. David Meenagh of Cardiff Business School has shown that the high volatility of the All-Share index is consistent with rational investors attaching varying weights to reasonable possible scenarios.
It's impossible to distinguish between these competing explanations for excess volatility. But perhaps we don't need to do so, because both imply the same thing - that it's quite possible that the fall in inflation expectations does not mean that the actual inflation outlook has improved much.
