Lorenzo Bini Smaghi

Third, central banks need to be very careful in using information extracted from market data when conducting monetary policy. The anchoring of inflation expectations is a very important benchmark for assessing whether the stance of monetary policy has become too expansionary and whether there are risks of falling behind the curve. However, the pre-crisis period and the crisis itself have shown that expectations are not always formed in a rational way and might themselves be influenced by the behaviour of the monetary authorities. Quite often markets participants form their expectations by looking at central banks’ behaviour, on the assumption that the latter have better and more information about underlying inflationary pressures. Under these circumstances, market-based inflation forecasts tend to be biased and may react in a perverse way following a tightening of monetary policy. In particular, inflation expectations may be revised up, rather than down, after an interest rate increase, especially at the beginning of a tightening cycle. If the monetary authorities’ assumption that inflation expectations are well anchored proves to be wrong, the whole yield curve might move upwards and the decision to increase the rate of interest may result in a much sharper tightening than expected. ^[4]

Another problem with inflation expectations concerns their measurement, especially in periods of financial turbulence, when the liquidity of the underlying instruments can affect their signalling content. A further distortion may arise when the central bank is itself a major buyer and holder of indexed-linked assets, which may distort prices and thus the information content. Measurement problems arise also with other components of the analytical framework, such as the output gap. Experience shows that measurement of the output gap varies over time. For instance, when measured ex post, with the data available until 2008, the US output gap over the period 2002-2004 turned out to be very small, even non-existent, while ex ante it was estimated at around 2% of GDP. ^[5]

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