Does an Unexpected Reduction in Economic Policy Uncertainty Impact Inflation Expectations?

Abstract

Evidence indicates that an unexpected reduction in the economic policy uncertainty lowers inflation expectations. We perform a counterfactual analysis to determine what would have happened to inflation expectations when the exchange rate, economic growth and consumer price inflation channels are shut off in transmitting unexpected reduction in economic policy uncertainty. The actual inflation expectations decline more than the counterfactual reaction. This suggests that an exchange rate appreciation and reduction in the consumer price inflation, following an unexpected reduction in the economic policy uncertainty, lead to further reduction in the inflation expectations. This suggests that an unexpected reduction in the economic policy uncertainty directly lowers inflation expectations and may lead to anchoring of inflation expectations.