Inflation Tolerance Bands and Private Sector Beliefs

This paper estimates a New Keynesian model with a nonlinearity in the monetary policy rule to capture the practice of inflation targeting with target zones or tolerance bands. Private-sector agents form subjective expectations, update their beliefs over time using a perceived model of the economy, and are subject to shifts in sentiment. The model is estimated using data on realized macroeconomic variables and survey data on expectations for four inflation-targeting economies: Australia, Canada, New Zealand, and Sweden. The results show that central banks do not treat target bands as zones of inaction. Their policy reactions when inflation falls within the band are comparable to or even exceed the reactions when inflation moves outside the band, and they always satisfy the Taylor principle. Private-sector expectations respond similarly to structural and sentiment shocks regardless of the inflation regime. In all cases, the data favor the simpler specification in which agents form expectations based on linear perceived laws of motion, without accounting for the nonlinearity induced by monetary policy.