How central banks lost control of inflation expectations
Ricardo Reis in this paper conducts an institutional postmortem of central banks’ failure to prevent the 2021-2022 inflation surge. Rather than a formal econometric model, Reis uses historical analysis, institutional review, and theoretical reasoning to diagnose why the existing monetary policy framework, despite delivering two decades of low inflation, broke down. He examines central bank communications, policy decisions, and the interpretation of shocks through the lens of the Phillips curve framework.
Findings:
Four structural causes of failure:
- Misdiagnosis of shocks: Unusual large shocks (COVID-19, supply chain disruptions, Ukraine war) were consistently interpreted through Phillips curve lenses as justifying loose monetary policy, even when inflation was rising.
- Neglect of expectations data: Strong belief that inflation expectations were firmly anchored led policymakers to dismiss early warning signals from expectations measures.
- Over-reliance on past credibility created an illusion of unlimited room to focus on real activity recovery, underpredicting resulting inflation.
- Strategy revision tolerance: Framework changes made central banks more tolerant of higher inflation due to falling returns on government bonds.
Core mechanism:
The paper argues that inflation expectations became unanchored not through a single mistake but through a tolerance for inflation that persisted even after large deviations from target. This tolerance was built into the institutional framework and policy strategy.
Policy implications:
Reis recommends: (i) accepting lower future real activity, (ii) vigorous near-term rate hikes to re-anchor expectations, (iii) reasserting price stability as the primary goal, and (iv) revising upward the relative costs of high inflation while refocusing on supply-side policies.
The analysis provides a framework-level diagnosis rather than a quantitative decomposition, emphasizing that the inflation surge resulted from how the policy regime interpreted and responded to shocks rather than from the shocks themselves.
Why did inflation rise and fall in 2021-24? Channels and evidence from expectations
Author: Ricardo Reis
From: London School of Economics
How firms’ longer-run inflation expectations became untethered
This paper by Ursel Baumann, Annalisa Ferrando, Dimitris Georgarakos, Yuriy Gorodnichenko, and Timo Reinelt analyzes euro area firms’ inflation expectations using the ECB’s Survey on the Access to Finance of Enterprises (SAFE). It tracks one, three, and five-year-ahead expectations across five quarterly surveys from June 2023 to September 2024, assessing anchoring through three measures: (1) convergence to the ECB’s 2% target, (2) disagreement across firms, and (3) sensitivity of longer-term to short-term expectations.
Findings
- Short-term expectations improved: Firms’ one-year-ahead median expectations fell from 5.0% (June 2023) to 2.7% (September 2024), tracking closely with the actual disinflation from 5.5% to 2.2%. This suggests the disinflation episode successfully lowered short-run inflation expectations.
- Longer-term expectations remain above target: Despite modest declines, median five-year-ahead expectations only fell from 3.0% to 2.9%—remaining above the ECB’s 2% target. More concerning, the mean expectations are skewed upward, with a “thick tail” of firms expecting inflation significantly above target in the longer run.
- Disagreement persists: While one-year disagreement declined modestly, disagreement at three- and five-year horizons remained stable and substantially higher than professional forecasters’ disagreement. Standard deviations for longer-term expectations (~1% for professionals vs. ~2-3% for firms) signal persistent uncertainty.
- Sensitivity increased sharply: Most strikingly, the correlation between short-term and long-term expectations rose sharply: the regression coefficient for five-year on one-year expectations jumped from 0.38 (June 2023) to 0.67 (September 2024). For professional forecasters, this coefficient remained stable at 0.15 and was not statistically different from zero by 2024 Q3. This increased sensitivity indicates that longer-term expectations are increasingly driven by transitory short-term shocks, the opposite of what anchored expectations would suggest.
This paper validates Reis’s core argument that expectations anchoring is fragile and harder to restore than maintain. Despite 18 months of successful disinflation, firms’ longer-term expectations remain increasingly sensitive to short-term shocks, confirming that credibility restoration is difficult and requires decisive, broad-based central bank action. The contrast between firms’ and professionals’ anchoring highlights why credibility must extend beyond financial markets, a key insight in Reis’s analysis.
Do Inflation Expectations Become More Anchored During a Disinflation Episode? Evidence for Euro Area Firms
Authors: Ursel Baumann, Annalisa Ferrando, Dimitris Georgarakos, Yuriy Gorodnichenko, Timo Reinelt
From: European Central Bank, University of California, Berkeley, Federal Reserve Bank of San Francisco
