Deflationary Shocks And De-Anchoring Of Inflation Expectations

with Fabio Busetti, Davide Delle Monache, Andrea Gerali and Alberto Locarno (Bank of Italy).

Venue: Board Room - Central Bank of Ireland

Time: 17 April 2015 at 13.00

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Link to paper

Abstract. A prolonged period of low inflation can heighten the risk of inflation expectations deanchoring from the central bank’s objective, particularly when monetary policy rates are near the zero lower bound. This paper investigates the effects of a sequence of deflationary shocks on expected/realized inflation and output. To do so we consider a simple New Keynesian model where agents have incomplete information about the working of the economy and form expectations through an adaptive learning process (in the sense that they behave like econometricians, using regressions to anticipate the future value of the variables of interest). The model is simulated with euro area data over the period 2014-16 under assumptions of both rational expectations and learning. The main findings are the following: (i) under learning, price dynamics in 2015-16 is 0.6 percentage points lower on average than in the case of fully rational agents, as inflation expectations are strongly affected by repeated deflationary shocks; (ii) the learning process implies a (data-driven) de-anchoring of inflation expectations from the central bank’s target, which would be perceived by economic agents to fall to 0.8 per cent at the end of 2016; (iii) output expectations would also be lower in the case of learning, resulting in a slower recovery of economic activity.