The Impact of Anchored Expectations on Disinflation Costs

Central Bank Credibility and Inflation Expectations

Consider two countries, both with a stated inflation target of 2%. The central bank in Country A has a long and consistent track record of meeting this target, earning significant public trust. In contrast, the central bank in Country B has frequently missed its target, and its policy announcements are often viewed with skepticism. If both countries experience an identical, temporary external shock that pushes current inflation to 5%, how would the public's long-term wage and price-setting behavior most likely differ between the two countries?

The Credibility Gap: Actions vs. Announcements

True or False: If a central bank has established high credibility and successfully anchored the public's inflation expectations at 2%, a sudden, temporary increase in oil prices that pushes current inflation to 5% will likely cause long-term wage negotiations to immediately incorporate an expectation of 5% future inflation.

The Challenge of Building Credibility