Monetary policy and the term structure of inflation expectations with information frictions

Abstract

I estimate how the term structure of inflation expectations in the United States responds to monetary policy shocks from 1982 to 2019. Studying the entire term structure uses all available data and allows me to examine whether forecasts at different horizons respond differently to the same shock, which may influence bond pricing, investment decisions, and the term structures of real and nominal interest rates. Survey forecasts of inflation (taken from the Survey of Professional Forecasters) are available at many horizons, but combining these in a consistent way is challenging because of information frictions and the number of available forecasts. I extend the unobserved components model to include additional covariates and allow for information frictions, a combination of features that allows me to identify the effects of monetary policy shocks, which I do using an instrumental variable. I find that a contractionary monetary policy shock twists the term structure of inflation expectations, raising short-run expectations while lowering long-run expectations, which suggests that long-run expectations are not well anchored. I also show that monetary policy actions taken throughout the recession beginning in 2008 propped up long-run inflation expectations from 2009 to 2014.