Inflationary Sentiments and Monetary Policy Communcation

We develop a DSGE model in which the conduct of monetary policy influences agents' inflationary sentiments, defined as waves of pessimism about how aggressively the central bank will react to inflation in the future. Monetary policy alternates periods of active inflation stabilization (i.e., active regime) and periods during which the emphasis is mainly on output stabilization (i.e., passive regime). Deviations from the active regime can be long or short lasting. When observing passive monetary policy, agents do not know the nature of the deviation and have to learn which type of passive regime is in place. As the central bank deviates from the active monetary policy for a longer and longer period, inflationary sentiments progressively spread among agents, who get increasingly convinced that the central bank might have switched to the long-lasting passive regime. Mounting inflationary sentiments have the effect to make the inflation-output gap trade-off worse and to depress private sector's welfare. When the model is calibrated to U.S. data, we find that inflationary sentiments sluggishly rise as the Federal Reserve deviates from active monetary policy. Such a dynamic for sentiments implies that (i) inflation drifts up for several years in response to a cost-push shock and (ii) the Federal Reserve has a large leeway in accommodating this type of shocks. Increasing the transparency of the Federal Reserve is found to improve welfare by anchoring inflationary sentiments. Gains from transparency are even more sizeable in periods when the persistence of shocks is high and for countries whose central bank has failed establishing a strong commitment to keeping inflation under control.