Disturbed Household Beliefs and Their Lasting Impact on Consumption

Abstract: I exploit the empirically documented comovement in households' expectations to identify what I call sentiment shocks. These disturbances shift the entire system of their economic perceptions causing deviations from fully rational expectations. The estimated shock series is correlated with consumer sentiment measures yet remains distinct from standard macroeconomic shocks. A Structural VAR analysis shows that sentiment disturbances have large and long-lived effects on household consumption, with the response of durable goods spending being especially strong. Sentiment shocks account for over 30% of the volatility in durable consumption and around 20% in non-durables at horizons of one to two years. I extend an otherwise standard New Keynesian model by introducing sentiment shocks that trigger a deviation of expectations from the rational benchmark. I present analytical results demonstrating that, depending on parameter values, a positive sentiment shock can generate fluctuations of either sign in output, inflation or the interest rate. The parameter estimates suggest that the high persistence of sentiment disturbances gives rise to prolonged effects on the model economy, consistent with the empirical impulse responses. Based on the estimated parameters, the quantitative results imply that the equilibrium effects of sentiment shocks on output and inflation are primarily driven by expectations of future interest rate changes. The latter reflects the anticipated monetary policy reaction to expected output fluctuations arising from sentiment disturbances.