The Soft Tyranny of Inflation Expectations

Abstract

Abstract The degree of anchoring of inflation expectations is a key determinant of outcomes in all modern macroeconomic models, inspired by the experience of the 1970s. For monetary policy‐making today, however, the sensitivity and relevance of measured inflation expectations is more questionable. The British economy, beset by a series of significant shocks in 2008–11, while operating an inflation targeting regime, provides a case with which to explore these issues. Five conclusions emerge given current monetary and economic structures: reliable forecasts for domestically generated inflation can be made taking inflation expectations as anchored; movements in measured short‐term inflation expectations are uninformative for forecasts; financial markets can distinguish between increased economic uncertainty and uncertainty about monetary credibility; real wages do not automatically respond to rises in household inflation expectations; monetary policy should be set in accord with the best medium‐term forecast for inflation without adjustment for inflation expectations in and of themselves.

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