Monetary Policy, De-Anchoring of Inflation Expectations, and the 'New Normal'

Abstract

Persistently low inflation rates in the Euro Area raise the question whether inflation is still credibly anchored to the Euro-system's medium term target of below, but close to 2%. The purpose of this paper is twofold. First, we investigate why agents' expectations that over the business cycle inflation will remain in line with the target begin to falter. Our hypothesis is that agents form expectations in terms of their confidence in the "normal regime", which is updated observing the state of the economy. Second, we study how the de-anchoring of expectations interacts with monetary policy determining whether the central bank is still able to achieve its target-and hence re-anchor inflation expectations-or whether the system drifts away towards depressed states of low inflation and output. Two are our main findings. The first is that, facing unfavourable shocks, if inflation expectations "fall faster" than the policy rate, and the zero lower bound is reached without correcting the shock, the system converges to a new steady state-the "new normal"-with permanent negative gaps. The second is that a more aggressive monetary policy is ineffective both at the ZLB and above the ZLB, when the shock is large and/or when the reactivity of inflation expectations is high enough. This last finding seems to support the necessity, in those conditions, to abandon conventional monetary policy and to switch to an aggressive reflationary policy that prevents the entrenchment of deflationary expectations.

Phillips Curve and Output Expectations: New Perspectives from the Euro Zone

“…The absence of a significant disinflation first (in US and Europe), and of a strong price recovery then (in particular in the Euro Zone), pushed researchers to wonder if the relationship between economic slack and inflation could still be valid. The suggestion coming from Hicks (1946) and Lucas (1973) is that inflation expectations cannot be deemed to be independent of the economic trend (Hicks 1946); therefore the relation inflation-economic slack described by standard expectation-augmented Phillips Curve might be misleading (Gobbi et al 2018). In this respect, our empirical PC responds precisely to this interrogative: inflation gap expectations are replaced by output gap expectations, using a mathematical expedient.…”

“…We can therefore define two macroeconomic regimes depending on the state of expectations in which the PC is different (see also Nalewaik 2016;Gobbi et al 2018;Hooper et al 2019). When expectations are anchored (AE regime), equation ( 8) shows a seemingly old Keynesian PC whose estimation would yield the structural slope β 2 .…”

“…In this respect, the president of the Federal Reserve Bank of Boston Rosengren (2018), has declared that the FED should define an inflation range between 1.5 and 3%, rather than the actual medium-term target of 2%, in order to avoid hitting the zero lower bound of interest rates to meet the objective. The suggestion coming from Gobbi et al (2018) instead, is to abandon conventional monetary policies, given their inability to stimulate enough the economy. On the contrary, they recommend to adopt aggressive reflationary policies, aimed at boosting the level of economic activity through a massive direct public spending and a reduction in the taxation level.…”

Inflation puzzles, the Phillips Curve and output expectations: new perspectives from the Euro Zone

“…We can therefore define two macroeconomic regimes depending on the state of expectations in which the PC is different (see also Nalewaik 2016;Gobbi et al 2018;Hooper et al 2019). When expectations are anchored (AE regime), Eq.…”

Domestic and Global Determinants of Inflation: Evidence from Expectile Regression*

“…find evidence of a long-run positive relation between inflation and working age population growth in euro area countries, implying that the ageing process in the euro area may have put downward pressures on inflation. More recently the increased risks of de-anchoring of inflation expectations, signalled among others byBusetti et al (2017),Natoli and Sigalotti (2018) andGobbi, Mazzocchi and Tamborini (2019), may also have contributed.© 2021 The Department of Economics, University of Oxford and John Wiley & Sons Ltd Domestic and global determinants of inflation…”