better anchored when countries adopt an inflation targeting regime.<sup>18</sup> IMF (2018) reports that multiple measures of the degree of anchoring of inflation expectations point to an improvement in the anchoring of expectations over the past two decades. However, there has been considerable heterogeneity in the extent of anchoring across emerging market economies.<sup>19</sup> In the context of Brazil, the literature examines a wide range of factors that might diminish the beneficial effects of inflation targeting on anchoring, broadly concluding that central bank transparency, central bank credibility, and the country’s fiscal position are all important in shaping inflation expectations. De Mendonça and Galveas (2013) show that, when controlling for central bank transparency, the forward-looking and hybrid specifications of the Phillips curve are more suitable for explaining current inflation than the purely backward- looking specifications. Yet, inflation expectations react more strongly to actual inflation, exchange rate movements, and output shocks when there is a problem of central bank credibility (Cortes and Paiva 2017). A deterioration in the fiscal position could also impede the anchoring of inflation expectations because of fears that monetary policy will be constrained, especially in cases where high interest rates imply unstable public debt dynamics (Cerisola and Gelos 2009; de Mendonça and Veiga 2014).<sup>20</sup>

# 4. Inflation expectations: Trends and anchors

Inflation expectations can provide valuable evidence about the credibility of a central bank. As documented by many studies, there is a close link between inflation expectations and monetary policy effectiveness. The more credible households and firms consider the central bank, the more likely inflation expectations are well anchored. In turn, wellanchored inflation expectations are found to support the effectiveness of monetary policy. Assessing and improving the degree of anchoring of inflation expectations are thus critical tasks for monetary policy makers.

# 4.1. Evolution of inflation expectations

In both advanced economies and EMDEs, long-term (five-year-ahead) inflation expectations have fallen during the past two to three decades. After declining rapidly 18 Estimations that allow for time-varying coefficients indicate that, although inflation expectations are better anchored in advanced economies than in EMDEs, anchoring has improved in both groups over time (IMF 2016). Other studies offer similar findings. Capistrán and Ramos-Francia (2010) and Mehrotra and Yetman (forthcoming) conclude from data for a large sample of EMDEs that inflation targeting has affected inflation expectations. Studies of Mexico, Brazil, and South Africa find that the adoption of inflation targeting has helped anchor expectations in each case (Carrasco and Ferreiro 2013; Cerisola and Gelos 2009; and Reid 2009, respectively). However, Kabundi, Schaling, and Some (2015) show that, in South Africa, even with inflation targeting, expectations of price and wage setters (businesses and trade unions) were higher than the upper bound of the official target band, while expectations of analysts were within the target band. This study also finds that expectations of price and wage setters were substantially influenced by lagged inflation, but that those of analysts were not.

> 19 IMF (2018) focuses on four measures: absolute deviation of three-year-ahead inflation forecast from target, variability of inflation forecasts, dispersion of inflation forecasts, and sensitivity to inflation shocks. In the context of a small macroeconomic model, IMF (2018) also shows that better-anchored inflation expectations reduce inflation persistence and limit the pass-through of currency movements to domestic prices.

> 20 Using a dynamic stochastic general equilibrium model calibrated to the United States, Eusepi and Preston (2018a, 2018b) conclude that government liabilities can reduce the effectiveness of monetary policy in controlling inflation in economies with high government debt under imperfect knowledge.

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