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Managing the risks of inflation expectation de-anchoring

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  • Christoffel, Kai
  • Farkas, Mátyás

Abstract

This paper investigates the implications of a potential loss of credibility in the central bank’s ability to bring inflation back to target in the medium-term (”de-anchoring”). We propose a monetary policy framework in which the central bank accounts for de-anchoring risks using a regime-switching model. First, we derive the optimal monetary policy strategy, which balances the trade-off between the welfare costs of a stronger response to inflation and the benefits of preserving the central bank’s credibility. Next, we apply this framework in a medium-scale regime-switching DSGE model and develop a method to assess de-anchoring risks in real time. Using the post-COVID inflation episode in the euro area as a case study, we find that an explicit ”looking-through” strategy would have only modestly increased de-anchoring risks. These findings highlight the importance of monitoring de-anchoring risks in monetary policy design. JEL Classification: D83, D84, E10

Suggested Citation

  • Christoffel, Kai & Farkas, Mátyás, 2025. "Managing the risks of inflation expectation de-anchoring," Working Paper Series 3082, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20253082
    Note: 85234
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    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General

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