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.

Monetary Policy, Rational Confidence, and Neo-Fisherian depressions

“…Since, as a consequence of the CF, inflation expectations deviate from the central bank's target, this mechanism rationalizes the notion of "deanchoring" of expectations in terms of excess sensitivity of long-run inflation expectations to short-run states of the economy (Bernanke, 2007;Gürkaynak et al, 2010;Buono and Formai, 2016;Carvalho et al, 2017;Fracasso and Probo, 2017;Gobbi et al, 2019).…”

“…We draw on the idea of "regime switch" put forward by Arifovic et al (2017) and re-elaborated by Gobbi et al (2019). Let agents observe, at any point in time t, a negative output gap.…”

“…11 The most popular application to binary exclusive events as in our case is the so-called logit model, where z t is a linear combination of observed variables 12 See Gobbi et al (2019). 13 It plays a role analogous to the gradient of recursive revisions of estimated parameters in learning models of the data generation process (Evans and Honkapoja, 2001;Evans and McGough, 2018b).…”

“…Firstly, in section 3 we introduce agents' long-run expectations based on their probabilistic beliefs about the future state of the economy. As in Arifovic et al (2017) and Gobbi et al (2019), upon observing a depression state of the economy, i.e. negative output and inflation gaps, agents elaborate a "regime switch hypothesis", that is, they assign probability p to the hypothesis that the current state will revert to the zero-gaps equilibrium ("normal regime") against the probability 1−p that it will not ("depression regime").…”

Refinancing as an element of control over inflation

“…It points to the lack of accuracy of the previously proposed econometric methods and offers better instruments to increase the accuracy of the made forecasts. Gobbi et al (2018) apply Keynesian models based on the equations describing the Taylor rule for inflation targeting, the inflation lag in the Phillips Curve, as well as the equations of the inflation rate, the CB's refinancing rate and the "natural" interest rate corresponding to the overall economic equilibrium. All the models are econometric.…”