Staff Working Paper No. SWP 1,175
By Mridula Duggal
This paper studies how inflation expectations respond to monetary-policy regime changes. I develop a New Keynesian model with trend inflation and adaptive learning in which adopting inflation targeting (IT) is a downward shift in the central bank’s inflation objective. Under rational expectations, expected inflation adjusts on impact. Under adaptive learning, beliefs update gradually and expectations adjust only partially between announcement and implementation. I then use professional-forecaster surveys for 32 countries and exploit staggered IT adoption to trace expectations and realised inflation around regime transitions. Empirically, inflation declines following adoption, while survey expectations exhibit little systematic adjustment. The results indicate that inflation leads expectations, at odds with the canonical New Keynesian rational-expectations prediction, and imply that – following the adoption of IT – credibility can be built over time as policy delivers lower inflation outcomes.
Targeting inflation expectations? 