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Central banks may be forced to raise rates higher if they allow doubts over their policy path to push inflation expectations higher, Francesca Monti says.
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A lack of clarity around the future path of monetary policy and the perception that policy is too loose could push up inflation expectations, forcing central banks to raise rates above neutral levels, according to Francesca Monti, a former Head of Modelling at the Bank of England's Monetary Policy Outlook division.
Uncertainty can prompt rises in inflation expectations which in turn feed through to changes in actual inflation, according to Monti, who is now Deputy Director at the Qatar Centre of Global Banking and Finance.
"Until recently, people were worried that there was not enough policy space to bring inflation back up to target, but now the situation might be changing. If people start worrying that monetary policy is looser than it should be, this makes long-run inflation expectations drift up in our set- up," Monti said in an interview, referencing research she carried out with BOE economist Riccardo Masolo.
If long-run inflation expectations do move higher, policymakers should act decisively, she said: first they should try to dispel uncertainty about their plans or capacity to act effectively via communication, but if this fails then action is needed.
"If there remains some lingering uncertainty in the people's mind … because of their uncertainty about the efficacy of different policies or because they don't trust the central bank fully …and if people start being more worried about high rather than low inflation, our model suggests that policy should track a path above the natural level," she said.
NO FALSE COMFORT
She warns against taking comfort from steady average inflation expectations, whether of households or business. For example, a rising share of firms or market participants might anticipate sharply higher inflation even if these expectations are offset on average by those expecting lower inflation.
In other work, with IMF economist Roland Meeks, Monti has argued that the distribution of expectations, rather than just the average, is an important source of information about the dynamics of inflation expectations and inflation. LSE professor Ricardo Reis has made a similar point, she noted.
On Thursday, in an award ceremony lecture, Reis said inflation alarm bells are ringing, citing options pricing showing market participants putting a 30% chance on price rises getting out of hand, as investors cast doubt on central banks' willingness to tackle rising inflation. On the same day the newly-appointed BOE Monetary Policy Committee member Catherine Mann, at a Euro50 Group meeting, said she paid close attention to the change in momentum in inflation expectations, rather than the headline figure.
Mann has also noted that while inflation expectations may matter little at a time of low and stable inflation, when price setters and consumers pay less attention to prices, they carry more weight when inflation is high.
"There is a lot of evidence to support Catherine Mann's view. People tend to be unaware of inflation when it's low and stable, but are much more informed when inflation is high," Monti said.
"The question of which expectations are the relevant ones is thorny, so it makes sense for policymakers to monitor inflation expectations of various actors in the economy -- markets, producers, households. It is important to focus on long-run inflation expectations, which really give a sense of the agents' perceptions about monetary policy," she said.