Reputation key to anchoring inflation expectations

A new ECB working paper develops a model showing how central bank reputation is crucial for anchoring long-run inflation expectations. It quantifies the benefits of stable expectations and the trade-off policymakers face when responding to inflationary shocks.

Reputation's anchoring effect

Policymakers often respond forcefully to inflationary shocks to prevent inflation expectations from 'de-anchoring'.

This ECB working paper introduces a model where households and firms are imperfectly informed about the central bank's objectives, learning from its policy choices.

This creates a 'reputation channel': a central bank perceived as more hawkish leads to lower and less responsive long-run inflation expectations.

The model shows policymakers are willing to raise interest rates more aggressively after adverse supply shocks, accepting short-run output costs to secure more stable expectations.

The 2021 Brazil episode is a key example, where the central bank tightened policy preemptively, explicitly warning of unmoored expectations, contrasting with advanced economies that delayed tightening.

Quantifying the reputation dividend

The study quantifies the reputation channel by estimating the sensitivity of long-horizon inflation expectations to interest rate surprises using high-frequency identification.

Brazil shows large negative elasticities: a 1 percentage point Selic rate surprise correlates with a 0.48 percentage point decline in market-based inflation compensation, unlike advanced economies where expectations are more anchored.

The calibrated model, featuring slow learning and an inflation bias, reveals a 'reputation dividend.'

As credibility accumulates, inflation expectations anchor more firmly, allowing central banks to stabilize inflation with more modest real rate movements.

Credibility: A costly investment

This research underscores the critical, often costly, role of central bank credibility in managing inflation expectations.

It highlights that preemptive, aggressive action, though painful in the short term, builds a reputation dividend that pays off in long-term stability.

For central banks with lower initial credibility, the path to anchored expectations demands a higher price in terms of immediate output costs.