# 4.2. Roles of global and domestic shocks in anchoring inflation expectations

The time-varying model described above is extended to estimate the response of inflation expectations to shocks from two sources, global and domestic. Examples of domestic shocks include unexpected electoral outcomes, wage disputes, and currency movements. Global shocks (surprises) could stem from sudden movements in food prices, oil prices, global economic activity, and financial conditions in major advanced economies.<sup>22</sup> In the model, a global inflation shock is defined as the first principal component of national inflation shocks for the full sample of countries (Appendix 3). A domestic inflation shock is defined as the residual from a regression of the national inflation shock on the global inflation shock.

The regressions produce four major results (Figure 5). First, for the median economy in each country group, the sensitivity of inflation expectations to both types of shocks is positive, indicating imperfect anchoring. Second, in the case of advanced economies, there was a gradual decline in the sensitivity of inflation expectations to global shocks from the 1990s to the late 2000s, followed by a large one-time drop during the global financial crisis. There was a much less pronounced downward trend in the sensitivity of inflation expectations to domestic shocks than to global shocks. These results imply that, in advanced economies, the improved anchoring of expectations has been partly driven by the reduction in the sensitivity of inflation expectations to global shocks.

Third, for EMDEs, the sensitivity of inflation expectations to domestic shocks gradually fell during 2005-12, and since 2012 has been stable. There has also been a slight decline in the sensitivity of expectations to global shocks since 2000. Finally, inflation expectations appear to be more sensitive to both global and domestic shocks in EMDEs than in advanced economies, implying weaker anchoring of expectations in the former group. The robustness of the results is tested by replacing the global shock, as described above, with an oil price shock, food price shock, global liquidity shock, and global output gap shock. These exercises lead to broadly consistent findings with the headline results.

# 5. Determinants of anchoring expectations

The improved anchoring of five-year-ahead inflation expectations over time in advanced economies and EMDEs, as suggested by the time-varying model in the previous section, may be associated with policy reforms aimed at increasing central bank credibility since the early 1990s (Mishkin 2007). Using the estimated sensitivity of inflation expectations as a dependent variable, panel regression models are used to assess which factors determine the degree of anchoring of expectations (Appendix 3). The explanatory variables in the models include the presence of an inflation targeting regime, central bank transparency, the presence of a fixed exchange rate regime, financial openness, trade openness, and fiscal sustainability.

# Inflation targeting and central bank transparency. If central banks in advanced economies

> 22 De Pooter et al. (2014) examine how foreign and domestic news surprises affect (market-based) inflation expectations in Brazil, Chile, and Mexico, using daily data. In their framework, foreign news surprises stem from macroeconomic developments in the United States and China and fluctuations in oil and food prices. They report that U.S. nonfarm payroll data releases have a significant impact on long-term inflation expectations in Chile and Mexico, while there is no corresponding impact in Brazil. The impact of news related to oil and food prices is not statistically significant.

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