SERIE RESEARCH MEMORANDA Consumers’ inflation expectations and monetary policy in Europe

Outline This paper analyses the effects of monetary policy decisions on inflation expectations of European consumers. Using a novel approach that does not assume unbiasedness of expectations, which makes use of survey data on expected future as well as perceived past price developments and allows for non-normal peakedness and asymmetry, we convert qualitative survey responses of consumers in various European countries into quantitative time series of inflation expectations. After checking the rationality of the constructed expectations measures, we investigate the effects of unanticipated movements in interest rates and inflation on inflation expectations across European countries. We inter alia seek to explore whether the reaction of consumers in countries with more credible central banks differs from the reaction of consumers in less credible countries. the European System of Central Banks (ESCB) is the rapid acquisition and maintenance of credibility for achieving price stability. Indeed, the credibility of the 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.' When the central bank lacks credibility, when the public does not believe that the central bank is going to do what it says it is going to do, 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 workers and businesses to price their goods and services too high. The attendant decline in employment and real activity complicates the environment for monetary policy, making the central bank's job more difficult. Thus the public's expectations of inflation need to be taken into account by the central bank when determining the stance of monetary policy, in order to Moreover, central banks need to assess the credibility of their monetary policy on an ongoing basis, and a key to this 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 will play an important role in any such exercise, given that what firms and households expect inflation to be over various horizons influences their wage and price decisions, thereby feeding into the measured inflation rate. Broadly speaking, there are two approaches to gauging …