Shocks to Inflation Expectations

IMF Working Papers, April 29, 2022

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The consensus among central bankers is that higher inflation expectations can drive up inflation today, requiring tighter policy.
The paper devises a novel method for identifying shocks to inflation expectations.
It estimates a semi-structural VAR where an expectation shock is identified as that which causes measured expectations to diverge from rationality.
Using data for the United States, the authors find results that are inconsistent with the standard New Keynesian model.
The paper discusses possible resolutions to this new puzzle.

Novel identification method: an expectation shock is defined as the shock that causes measured expectations to diverge from rationality.
Empirical framework: semi-structural vector autoregression (VAR).
Data: United States (specific series and sample not reproduced on the landing page).

A positive inflation expectations shock is:
- Deflationary: inflation falls.
- Contractionary: output falls.
- Associated with lower interest rates: interest rates fall.
These empirical results contrast with the prediction of the standard New Keynesian model, which predicts inflation and interest rate hikes following higher inflation expectations.

The findings create a new puzzle for macroeconomic theory because they contradict standard New Keynesian predictions.
The authors discuss possible resolutions to this puzzle (specific resolutions are discussed in the full paper).