Confidence in Central Banks and Inflation Expectations

In this paper we explore the consequences of losing confidence in the price-stability objective of central banks. We propose a new model that shows that losing confidence can lead to both, an inflation as well as a deflationary bias, depending on the perception of the objective function of the central bank. Both biases emerge as a steady state outcomes and increase the burden of the central bank to achieve its mandate. We validate the predictions of the model using a comprehensive new dataset on 50,000 individual observations across 9 countries and can identify and quantify inflation and the deflationary bias as a consequence of losing confidence in central banks objectives. We can confirm the predictions of our model as we can show that inflation bias exists for expectations above the target and a deflationary bias exist for expectations below. As one would expect both inflationary and deflationary bias are more pronounced for medium-run than short-run inflation expectations. Furthermore, we also test the prediction of the model that conservative or inflation-targeting central banks reduces the the magnitude of inflation and deflationary bias and find supporting evidence in our dataset. Among the Eurozone countries in our sample we can document, despite the same experience with the ECB, significant differences in levels of confidence and responses to it.