The Curve of Inflation Expectations and Firms’ Investments

Abstract

Using rich survey data on Italian firms, this paper studies the formation mechanisms of inflation expectations at different forecasting horizons. Starting from empirical evidence embedded in firms’ inflation expectation curve, we obtain 3 main findings: (1) firms extrapolate for long forecasting horizons, (2) inflation forecasts overreact (underreact) at long (short) forecasting horizons, (3) long-term inflation expectations impact investment decisions. Specifically, we find that a 1% wedge between the 4-year and 1-year ahead expected inflation is associated with a 0.8% increase in the probability of investing. What motivates this result? After ruling out alternative channels of (1) an increase in expected demand, (2) a decrease in supply of input goods, and (3) an improvement in financing conditions, we claim that a decrease in the perceived cost of capital is the main driver.