The divergence between core and headline inflation: Implications for consumers' inflation expectations

We show that US consumer inflation expectations are formed using a variant of adaptive expectations proposed by Mankiw et al. (2004). In particular, expectations behave differently when food and energy prices rise sharply relative to other prices. Using the recently proposed test of Homm and Breitung (2012), we analyze the 1982-2010 period and identify seven periods where the headline price index of personal consumption expenditures (PCEs) move explosively relative to the core PCE. During explosive periods, consumers rely more on past inflation in forming inflation expectations as compared to non-explosive periods. The importance of considering explosive periods in forming inflation expectations is also observed when CPI measures are considered. Finally, we find that during volatile periods inflation expectations are formed similarly as in normal periods. Our results indicate that the explosive behavior of food and energy prices should be taken into consideration when designing policies that aim to anchor inflation expectations.