The effect of monetary policy on inflation expectations: Evidence from a financial traders survey

Abstract

While financial market participants' actions are crucial for the effectiveness of the monetary policy, the literature lacks evidence on how traders form economic expectations. Studies have argued that economic agents' inflation expectations increase as a reaction to contractive monetary policy shocks, the so-called central bank (or Fed) information effect, but have not addressed the extent to which these responses are state-dependent. This study employs individual observations of more than 100 Chilean financial traders from 2010 to 2022 to analyze how they update inflation expectations in response to monetary policy surprises, when controlling for other relevant factors. The evidence indicates that traders' reactions to policy shocks depend on the actual inflation rate, suggesting a mechanism where observed inflation reflects the central bank’s credibility and, thus, affects responses to policy actions. Results show that the size of the update depends on the disagreement amongst traders and news concerning contemporaneous inflation.