Financial shocks and inflation expectations: Implications for modern central banking

This study investigates the causal impact of financial conditions on inflation expectations, with a particular focus on the evolving mandates of central banks since 1990s. As institutions increasingly incorporate financial stability alongside price stability, understanding the interplay between these objectives becomes critical. We seek to uncover: How responsive are private agents' inflation expectations to tightening and loosening financial shocks? And what role do monetary policies play in shaping these transmission asymmetries? Using state-dependent local projection methods combined with Kitagawa-Blinder-Oaxaca decompositions, we quantify the response of inflation expectations to financial shocks across monetary stances and time horizons. Evidence from the U.S. shows that consumers’ short-term expectations respond strongly to financial shocks, especially under severe stress. The results also show that Federal Reserve interventions under financial distress quickly transmit to the expectations channel, underscoring the need to integrate financial stability into inflation management.