Consumers' inflation expectations and monetary policy in Europe

JAN MARC BERK (*) I. INTRODUCTION The credibility of a central bank is probably the single most important factor determining whether the pursuit of an anti-inflation policy is associated with significant output and employment losses. (1) In Europe, for example, following the start of stage 3 of Economic and Monetary Union, a crucial objective for the European System of Central Banks has been the rapid acquisition and maintenance of credibility for achieving price stability. When a central bank lacks credibility, the public does not believe that the central bank is going to do what it says it will. As a result, expected inflation in the private sector will exceed the central bank's objective for inflation. These expectations will feed into the wage and price decisions of households and firms, causing some businesses and workers to overcharge for their goods and services. The resulting decline in employment and real activity complicates the environment for monetary policy, making the central bank's job more difficult. The public's expectations of inflation therefore needs to be taken into account by the central bank when determining the stance of monetary policy to achieve its objective (Kydland and Prescott, 1977; Barro and Gordon, 1983). Moreover, central banks need to assess the credibility of their monetary policy on an ongoing basis. A key to this ongoing assessment is knowing how the inflation expectations of the general public compare with the price stability objective pursued by the central bank. However, measures of expected inflation are also of interest by themselves, as forecasting inflation is a major task of any central bank. Measures of expected inflation play an important role in any such exercise, given that the inflation expectations of firms and households over various horizons influence their wage and price decisions, thereby feeding into the measured inflation rate. Broadly speaking, there are two approaches to gauging inflation expectations. (2) The first is to try to infer the expected infation rate from the prices of financial instruments (Bank of Canada, 1998; Mylonas and Schich, 1999). The primary advantage of looking at the prices of financial instruments is that these prices reflect the expectations of agents on which they have been willing to act. This forward-looking nature makes financial asset prices popular among central bankers (see Hordahlm [2000] and Angeloni and Rovelli [1998] for recent examples). If, for example, both nominal and index-linked bonds with identical risk, liquidity, and maturity characteristics are traded, it is in principle possible to obtain a very accurate measure of expected inflation (Barr and Campbell, 1997; Schmidt, 1999). However, in practice index-linked bonds are scarce, and where they are issued, it is usually more than just the determination of their returns that varies from nominal bonds. Thus it is often necessary to make str ong auxiliary assumptions to infer expected inflation from the prices of these nominal assets, thereby clouding the information content of the expected inflation series that has been derived. (3) The alternative approach is to simply ask a sample of the general public what they expect inflation to be over some specified time horizon by means of a survey. This direct approach has the advantage of obtaining a measure of expected inflation which is undistorted by any auxiliary assumptions. The primary drawback is that participants may not base their actual decisions on their survey responses. Moreover, the results of sample surveys are overly sensitive to sampling errors and to the precise formulation of the questions posed (Chan-Lee, 1980). This article deals with the use of quantitative information on inflation expectations of European consumers as derived from qualitative survey data for monetary policy purposes. More specifically, following the suggestion of Goodhart (1997), I investigate the information content of the expected inflation measures in the context of movements in actual inflation and short-term interest rates in Europe. …