The Role of Expectations in the Inflation Process in a Period of Exchange Rate Shock

In this paper, we analyze the role of inflation expectations in inflation dynamics. The hike in inflation in Turkey following the exchange rate shock in 2018 provides an interesting period to analyze whether the sensitivity of inflation to its main determinants, including expectations, has changed. To this end, we estimate a time-varying parameter Phillips curve model to focus on the changes in inflation dynamics. We also jointly study the formation of inflation expectations to further investigate how the setting of inflation expectations evolved over the course of the rapid rise and the following gradual decline in inflation observed since the second half of 2018. Our results reveal that inflation expectations play an important role in inflation dynamics; and that the sensitivity of inflation to expectations did not change much recently. Meanwhile, the sensitivity of inflation to the exchange rate has sharply risen and corrected only partially afterwards. However, the most notable change has been witnessed in the weight attached to the past inflation in forming expectations; agents pay higher attention to inflation realizations. Overall, our results reveal that inflation expectations and the exchange rate movements are the leading driving forces of inflation in Turkey, in which the interaction between them further amplifies the impact on inflation