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Monetary policy, de-anchoring of inflation expectations, and the 'new normal'

Lucio Gobbi (), Ronny Mazzocchi () and Roberto Tamborini ()

No 2018/04, DEM Working Papers from Department of Economics and Management

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

Keywords: Monetary Policy; Zero Lower Bound; New Normal; Inflation Expectations (search for similar items in EconPapers)
JEL-codes: E50 E52 E58 (search for similar items in EconPapers)
Date: 2018
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac and nep-mon
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Journal Article: Monetary policy, de-anchoring of inflation expectations, and the “new normal” (2019) Downloads
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