Monetary policy and inflationary shocks under imperfect credibility

In this note, we quantify the deterioration of achievable stabilization outcomes when monetary policy operates under imperfect credibility and weak anchoring of long-term expectations. Within a medium-scale Dynamic Stochastic General Equilibrium (DSGE) model, we introduce, through a simple signal extraction problem, an imperfect knowledge configuration in which price and wage setters wrongly have doubts about the determination of the central bank to maintain a fixed long-term inflation objective in the face of inflationary shocks. The magnitude of private sector learning has been calibrated to match the volatility of US inflation expectations at long horizons. We find that the costs of maintaining a given inflation volatility under weak credibility could amount to 0.25 percentage point (pp) of output gap standard deviation. ► We assess the monetary policy implications of imperfect credibility. ► Private agents do not have a perfect knowledge of the central bank’s inflation target. ► Cost push shocks can trigger wrongly perceived time variation in the central bank inflation target. ► The cost of weak credibility could amount to 0.25 pp of output gap standard deviation.