Underreacting to News or Responding to Change? Reexamining Macroeconomic Expectations

Deviations of market participants forecasts from full-information rational expectations (FIRE) are usually specified to arise from limited information or irrationality. Relying on a novel theoretical characterization, we present empirical evidence that these specifications are inconsistent with participants macroeconomic expectations, as measured by survey data. We attribute this inconsistency to macroeconomic models’ premise that the process driving outcomes is time-invariant or undergoes repetitive change. Our findings provide a new perspective on deviations from FIRE: what has been interpreted as participants underreaction to news or irrationality is better understood as their rational response to non-recurrent change in the process driving outcomes