Market perceptions of policy reaction functions affect inflation stability
A new Bank of Japan (BoJ) working paper estimates how market participants in Japan perceive the central bank's policy reaction function. The study reveals that these perceptions are state-dependent and significantly influence the stability of long-term inflation expectations.
Inflation coefficient adapts to policy shifts
The study estimates the policy reaction function of monetary policy as perceived by Japan's market participants, utilizing market survey data.
A key finding is that the coefficient for the inflation rate in the perceived policy reaction function is almost zero when the nominal interest rate is constrained by the effective lower bound.
This coefficient tends to rise during subsequent interest rate hike periods, following changes in central bank policy.
This suggests that market participants update their perceptions of monetary policy in response to actual policy changes, a finding consistent with previous research in other economies.
The analysis highlights that the effectiveness of monetary policy depends on private agents' expectations of policy responses based on economic and price developments.
Divergent expectations, persistent low rates
Despite the general increase in the inflation coefficient, a subgroup of market participants with long-term inflation expectations deviating downward from the 2 percent price stability target shows a persistently low coefficient, even during recent interest rate hikes.
This suggests that this group may anticipate an extended period of low interest rates.
Conversely, market participants who assume a stronger monetary policy response to inflation tend to have more stable long-term inflation expectations, anchoring them around the 2 percent target.
These results underscore that private agents' perceptions about monetary policy are state-dependent, and that macroeconomic stability and the effectiveness of monetary policy may vary over time.
Unveiling Japan's perception puzzle
This paper provides crucial insights into the nuanced dynamics of monetary policy perception in Japan, a long-underresearched area.
The identified heterogeneity in market expectations, particularly regarding the lower bound, highlights a significant challenge for central bank communication and policy transmission.
Understanding these state-dependent perceptions is vital for the Bank of Japan to effectively anchor inflation expectations and ensure macroeconomic stability.