Inflation expectations lag policy shifts, built by outcomes

The paper develops a New Keynesian model incorporating trend inflation and adaptive learning to analyze how inflation expectations respond to shifts in monetary policy regimes, specifically the adoption of inflation targeting (IT).

While rational expectations predict immediate adjustment, the model with adaptive learning suggests gradual belief updates.

Empirically, using professional-forecaster surveys from 32 countries, the study observes that inflation declines following IT adoption, yet survey expectations exhibit little systematic adjustment around the regime transition.

This finding contradicts the canonical rational-expectations prediction, indicating that inflation outcomes often precede shifts in public expectations, challenging a core tenet of traditional monetary theory.

The research highlights that the level of inflation expectations (mean of priors) does not discretely move at the moment economies transition between monetary regimes, as often assumed.

The research addresses a key puzzle illustrated by episodes like Colombia, where inflation and expectations declined around IT adoption, versus the United States, where expectations showed little discrete movement.

The findings imply that central bank credibility is not automatically granted upon the adoption of an inflation-targeting regime.

Instead, it is built gradually over time as monetary policy consistently delivers lower inflation outcomes.

This suggests that sustained performance in achieving price stability is crucial for anchoring long-term inflation expectations, rather than the initial policy announcement itself.

The study also finds little evidence of systematic changes in agents' responsiveness to new information around the introduction of IT, making it unlikely that the flat response of expectation levels reflects an offsetting change in the learning gain.