Inflation: The Role of Beliefs and Credibility
Paper Session
Friday, Jan. 5, 2024 8:00 AM - 10:00 AM (CST)
- Chair: Viral Acharya, New York University
The Central Bank's Dilemma: Look Through Supply Shocks or Control Inflation Expectations?
Abstract
Central banks in most advanced economies have reacted similarly to the increase in inflation that started in 2021. They initially looked through the rising inflation by leaving monetary policy relatively unchanged. Then, after inflation continued to increase, central banks pivoted by quickly tightening monetary policy. The pivot was explained, at least in part, as aiming to anchor drifting inflation expectations. Why might central banks want to look through supply-driven inflation sometimes and pivot away at other times? When does a change in monetary policy stance help anchor expectations? When is a strong monetary policy tightening compatible with a soft landing? In this paper we present a simple environment that helps clarify these issues by offering an optimal policy perspective on recent central bank behavior. In particular, we examine optimal policy in an environment where there is risk of wage-price spirals and where the central bank views wage- and price-setters as having bounded rationality. We show how this can provide a coherent explanation of many aspects of recent central bank behavior.The Market for Inflation Risk
Abstract
This paper uses transaction-level data on UK inflation swaps to characterize who buys and sells inflation risk, when, and with what price elasticity. This provides measures of expected inflation cleaned from liquidity frictions, and of the varying influences of market participants with different beliefs. We first show that this market is segmented: pension funds trade at long horizons while hedge funds trade at short horizons, with dealer banks as their counterparties in both markets. This segmentation suggests three identification strategies—-sign restrictions, granular instrumental variables, and heteroskedasticity—-for the demand and supply functions of each investor type. We find that swap prices absorb new information quickly, the supply of long-horizon inflation protection is very elastic, short-horizon price movements are unreliable measures of expected inflation as they primarily reflect liquidity shocks, and that long-horizon price movements overstates changes in expected inflation during important events if they were not cleaned from liquidity shocks.Pandemic-era Inflation and Interest Rate Expectations in the US: The Role of Supply Shocks and Central Bank Credibility
Abstract
We study expectations for inflation and central bank policy during the post-pandemic recovery in the United States using data from the options market, specifically on inflation and interest rates. While both average expectations and inflation uncertainty moved systematically upwards during the initial recovery, inflation uncertainty kept rising even as average expectations eventually normalized. Expectations for interest rates rose only with a lag, but subsequently displayed large mass in the right tail of the distribution. We evaluate theoretically whether these empirical patterns can be explained by shifts in the persistence of supply shocks, by markets perceiving the Fed’s response as simply being behind the curve (“policy error”), or by markets learning about the central bank’s stance on inflation.JEL Classifications
- E3 - Prices, Business Fluctuations, and Cycles
- E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit