## Managing Expectations: Inflation and Monetary Policy

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**Canonical URL:** [Managing Expectations: Inflation and Monetary Policy](https://www.imf.org/-/media/files/oap/oap-home/2023/october-2023-weo-ch2.pdf)

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### Persistent inflationary environment and recent dynamics
- Core inflation across 35 sample countries (accounting for approximately 81 percent of 2022 world output) showed elevated and persistent increases in 2022–2023.  
- Cross-economy deviations of inflation expectations from targets widened across advanced economies and emerging market and developing economies, with box-and-whisker distributions showing substantial dispersion.

### The role and behavior of inflation expectations
- Near-term expectations:
  - Near-term inflation expectations rose sharply, including "up to 4 standard deviation rise" for some measures.
  - Near-term expectations increased in importance in explaining current inflation dynamics, particularly in advanced economies.
- Long-term expectations:
  - Long-term (five-year-ahead) expectations remained broadly stable and on average anchored, showing no broad de-anchoring.
- Cross-agent agreement:
  - Professional forecasters, households, firms (textual analysis of earnings calls), and financial markets broadly agreed on the broad dynamics of near-term expectations, with greater state dependency since 2021 Q1.

### Empirical evidence from Phillips-curve estimates and instrumental-variable results
- Instrumental-variables estimates of the hybrid Phillips curve (pooled time series, quarterly data 1991:Q2–2023:Q1) find:
  - Near-term expectations have large positive coefficients on current headline inflation for both advanced economies and emerging market economies.
  - Standardized-regression results for the euro area, United Kingdom, and United States show near-term professional forecasters, financial markets, firms, and households with substantial estimated effects on current inflation; long-term measures show smaller effects.
- OLS versus IV estimates (pooled time series, 1991Q2–2023Q1):
  - Near-term expectations coefficients (selected reported values):  
    - Advanced economies mean groups OLS: 1.14*** (0.10)  
    - Advanced economies common IV: 0.82*** (0.08)  
    - Emerging market economies common IV: 0.42*** (0.10)
  - Output gap coefficients (selected): 0.06***, 0.12***, 0.14** (standard errors reported).
  - Lagged inflation coefficients vary by specification, including negative and positive estimates (e.g., -0.09*; 0.26***; 0.35***).
  - R-squared values reported include 0.70, 0.72, 0.48 for AE specifications and 0.67, 0.68, 0.56 for EME specifications.
  - Countries and observations: AEs 31 countries, 3379 observations; EMEs 17 countries, 1757 observations.
  - First stage F-statistics: Expectations 1745 (AE), 250 (EME); Output gap 478 (AE), 92 (EME).
  - Overidentification (p-value) reported as 0.94 (AE) and 0.21 (EME).
- Interpretation:
  - OLS estimates of the effect of expectations in the Phillips curve are upward biased relative to IV estimates.
  - Near-term expectations exhibit greater explanatory power than long-term expectations, especially recently.
  - In emerging markets, lagged (past) inflation retains a more prominent role.

### Structural and model-based findings on expectations formation
- Heterogeneous-expectations versus rational-expectations models:
  - Cost-push shocks are more persistent and monetary policy is less potent when a larger share of agents are backward-looking (heterogeneous expectations).
  - Impulse-response dynamics:
    - After a cost-push shock that increases inflation by 1 percentage point, the output gap increases because potential output falls by more than real GDP.
    - Monetary policy shock modeled as a 100 basis points increase in the policy rate: inflation response peaks after five quarters in the heterogeneous-expectations model and after three quarters in the rational-expectations model.
  - Sacrifice ratio (percent of output forgone to lower inflation by 1 percentage point, assumed policy brings inflation down over three years):
    - Sacrifice ratios are higher under heterogeneous-expectations than under rational-expectations.
    - The effect is larger in emerging market economies, reflecting a typically higher share of backward-looking learners.
- Optimal monetary policy under heterogeneous agents:
  - Optimal policy implies a slower path to return inflation to target when agents are heterogeneous and backward-looking.
  - Policy objectives and social welfare trade-offs show that deviating from a very rapid disinflation path can improve welfare outcomes under heterogeneous expectations.

### Policy interventions and implications for a softer landing
- Simulated policy interventions and calibrated impacts (deviation from baseline, percentage point):
  - Improvements in communication strategies are calibrated as the difference in the forward-looking share between representative advanced and emerging market economies.
  - Fiscal consolidation shock assumed to be a 1% consolidation maintained for 2 years.
  - Monetary policy tightening exercise uses a standard 100 bps tightening.
  - Simulations show that:
    - Improved monetary policy frameworks and communications can hasten reduction of inflation and inflation expectations and help achieve a softer landing.
    - Tighter cyclical policies, fiscal consolidation, and monetary tightening each influence inflation, inflation expectations, and the output gap with varying time profiles over 4, 8, and 12 quarters.
- Policy implications summarized:
  - Monitoring changes in agents' expectations formation process is key to understanding the trade-off between speed of inflation convergence to target and economic slowdown, and to calibrate monetary policy actions.
  - A smoother transition toward inflation targets might be needed to minimize welfare losses, especially when expectations are more backward-looking and shocks are persistent.
  - Improved monetary policy frameworks and communications can help achieve a softer landing by better informing agents' expectations.

### Measurement innovations and anchoring metrics
- ECFIE (Earnings-Calls-based Firm Inflation Expectations):
  - New measure based on text analysis of firms’ earnings calls capturing firms’ intensity of discussion of near-term inflation expectations.
  - ECFIE index defined as sum of InflationExpectationSentences_t,i divided by TotalSentences_t,i.
  - ECFIE correlates highly with survey-based firm expectations (Cleveland Fed survey for US and cross-country validations for selected economies).
- Anchoring metrics:
  - Multiple metrics show long-term expectations remain anchored for advanced economies and emerging market economies, including:
    - Root Squared Deviation from Inflation Target
    - Expectations' Variability
    - Expectations' Disagreement
  - Plots (smoothed with a trailing average of six years) indicate medians and interquartile ranges for AE and EM groups.

### Historical context and duration of past episodes
- Historical episodes analysis (sample 1989:Q4–2023:Q1; varying coverage by economy):
  - Episodes defined as four quarters of rising 1-year-and 5-year-ahead inflation expectations.
  - A total of 32 past episodes identified: 16 advanced economies and 16 emerging market economies.
  - On average, it took 3 years to revert to pre-episode inflation rates across historical episodes.

### Key conclusions and findings (concise)
- How have inflation expectations behaved pre- and post-pandemic?
  - Near-term inflation expectations rose sharply (up to 4 standard deviation rise).
  - Long-term expectations do not show signs of de-anchoring on average.
  - Inflation is so far roughly in line with the median from historical episodes; on average, it took 3 years to revert to pre-episode inflation rates.
- How important are expectations for inflation dynamics?
  - Near-term inflation expectations play a more important role for inflation than long-term measures, with rising explanatory power in the recent period.
  - In emerging markets, past inflation still plays a predominant role.
  - The passthrough tends to be higher when inflation is already elevated.

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_Source: https://www.imf.org/-/media/files/oap/oap-home/2023/october-2023-weo-ch2.pdf_