What drives policy rate expectations? Evidence from the post-pandemic monetary policy cycle

We investigate how demand and supply shocks, as perceived by markets, shaped revisions in expected ECB and Fed policy rates during the post-pandemic monetary policy cycle. To this end, we construct a measure of revisions in near-term policy rate expectations and embed it in a two-country daily BVAR model identified through sign and magnitude restrictions. Three patterns emerge. First, both central banks were perceived as more responsive to inflation than in the pre-ELB period, under both demand and supply shocks. Second, supply shocks were seen as being treated similarly to demand shocks, reflecting a lower perceived tolerance for supply-driven inflation. Third, supply shocks became a new source of cross-border spillovers in rate expectations. These findings point to a reconfiguration of perceived central bank reaction functions in high-inflation environments, when the risk of expectations de-anchoring becomes material.