Should policymakers be cautious when inflation expectations rise?

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In the face of massive economic activity and pressures from pent-up demand, a chorus of analysts and scholars have raised concerns that inflationary forces are increasing. Others have rejected the idea, claiming that the economy is still weakening significantly and that central banks remain credible, as evidenced by the well-anchored inflation expectations.

However, Jenkins noted that a key element to the central bank’s credibility is the idea of ​​”time inconsistency.” In the context of monetary policy, he said, it does when the public sees the central bank taking short-term measures that appear incompatible with its inflation target, causing the public to doubt the central bank’s ability to meet its announced inflation target.

“The dynamic is that monetary authorities, convinced that inflation expectations are well anchored, are giving in to the temptation to stimulate the economy more than the public expects, resulting in expectations being revised higher than announced long term policy. Jenkins said.

One solution to the problem of time inconsistency, Jenkins said, is to have an explicit agreement between the government and the central bank on the goal of the policy. With an easily understandable and transparent arrangement, the central bank can be held more accountable, which strengthens and maintains the credibility of the policy – as is the case in Canada.

However, the extent of the incentives currently in the works, as well as the additional incentives planned, could be seen as inconsistent with the long-term target of 2% inflation, leading the public to reassess their expectations. Jenkins added that the record-breaking stimulus package recently passed by the US Congress could create spillover effects that would multiply the risk of public inflation expectations rising.

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