Inflation Scares and Forecast-Based Monetary Policy

Central banks pay close attention to inflation expectations. In standard models, however, inflation expectations are tied down by the assumption of rational expectations and should be of little independent interest to policy makers. In this paper, we relax the assumption of rational expectations with perfect knowledge and reexamine the role of inflation expectations in the economy and in the conduct of monetary policy. Agents are assumed to have imperfect knowledge of the precise structure of the economy and the policymakers’ preferences. Expectations are governed by a perpetual learning technology. With learning, disturbances can give rise to endogenous inflation scares, that is, significant and persistent deviations of inflation expectations from those implied by rational expectations. The presence of learning increases the sensitivity of inflation expectations and the term structure of interest rates to economic shocks, in line with the empirical evidence. We also explore the role of private inflation expectations for the conduct of efficient monetary policy. Under rational expectations, inflation expectations equal a linear combination of macroeconomic variables and as such provide no additional information to the policy maker. In contrast, under learning, private inflation expectations follow a time-varying process and provide useful information for the conduct of monetary policy.

Introduction
Inflation expectations play a central role in the monetary policy process. Central banks regularly monitor and analyze information regarding inflation expectations, as reflected in surveys or financial markets. Moreover, forecasts of inflation are at the center of policy deliberations at inflation-targeting central banks and have arguably been equally important for policy decisions in non-inflation-targeting central banks such as the Federal Reserve and the European Central Bank.

Author: Athanasios Orphanides and John C. Williams

Source: Lancaster University Management School

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