Inflation Expectations – Role and Measurement for Monetary Policy

Inflation expectations play a crucial role in modern monetary policy, given their capacity to influence actual inflation and given their informative value on the central bank’s credibility with regard to safeguarding price stability. The risk of a de-anchoring of inflation expectations in the wake of soaring energy and commodity prices figured among the key motivations for international hikes in official interest rates between 2007 and mid-2008. But also the recent abrupt decline in headline inflation – driven by the collapse in energy and commodity prices as well as the sharp global recession – may bear the risk of affecting inflation expectations, this time downward. An appropriate conceptualization and measurement – in real time – of inflation expectations is therefore essential for successful monetary policy. Building on the current state of economic theory and central bank practice, this study addresses four questions: First, which agents’ or sectors’ inflation expectations should be considered? Second, what time horizon of inflation expectations is relevant for monetary policy decisions? Third, what are the relative merits and drawbacks of the various available measures of inflation expectations in the light of the answers to the first two questions? Finally, how do shocks to inflation expectations affect actual inflation in the euro area? The study finds, first, that to gauge future risks for inflation and to assess central bank credibility comprehensively across various constituencies, it would be desirable to capture wage and price setters’ inflation expectations better than so far. Second, besides the much-quoted long-term inflation expectations, also medium-term inflation expectations (beyond one and below five years) should be given due consideration. Third, the available empirical measures of inflation expectations only partly fit these conceptual requirements. Given the important limitations of the proxy measures currently available in the euro area, we recommend further research and improving data coverage. Finally, the study confirms empirically that shocks to expected inflation account for a considerable part of actual inflation dynamics. The influence is stronger for financial market-based measures and for forecasters’ inflation expectations than for measures based on consumer expectations. This may also reflect the longer time-horizon of these indicators. Thus, expectation shocks may represent a serious risk for price stability.