Long-term inflation expectations and inflation dynamics

Thórarinn Pétursson

Economics from Department of Economics, Central bank of Iceland

Abstract: After rising sharply following the Global Financial Crisis, inflation in Iceland has been low and stable in recent years despite a strong cyclical recovery. This not only reflects favourable external conditions but also coincides with a significant decline in long-term inflation expectations in financial markets. It is argued, however, that this market-based measure of inflation expectations actually underestimates the true decline in long-term inflation expectations of price setters. To extract this unobserved wedge between inflation expectations of price setters and financial agents, we estimate a time-varying parameter Phillips curve model for the inflation-targeting period since 2001, adjusting also for an unobserved risk premium in market-based inflation expectations. The empirical results suggest that the expectations wedge was significantly positive until early 2012, after which it starts to gradually decline towards zero. The true decline in long-term inflation expectations of actual price setters is therefore much steeper than is captured by the market-based measure and taking this into account results in a stable and plausible specification of the Phillips curve that can explain key features of the recent inflation developments in Iceland.

JEL-codes: E31 E32 E37 E52 (search for similar items in EconPapers)
Date: 2019-08
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.cb.is/library/Skraarsafn---EN/Working-Papers/Working_Paper_81.pdf (application/pdf)

Related works:
Journal Article: Long‐term inflation expectations and inflation dynamics (2022)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ice:wpaper:wp81

Access Statistics for this paper

More papers in Economics from Department of Economics, Central bank of Iceland Contact information at EDIRC.
Bibliographic data for series maintained by Central Bank of Iceland ( this e-mail address is bad, please contact ).