Title: De-anchoring of inflation expectations under learning and heterogeneity
Authors: Alberto Locarno - Banca d'Italia (Italy) [presenting]
Fabio Busetti - Banca d'Italia (Italy)
Davide Delle Monache - Bank of Italy (Italy)
Gerali Andrea - Bank of Italy (Italy)
Abstract: The purpose is to study how a prolonged period of subdued price developments may induce a de-anchoring of inflation expectations from the central banks objective. This is shown within a framework where agents form expectations using adaptive learning, choosing among a set of alternative forecasting models. Expectations are therefore non rational and heterogeneous: some agents are naive and form inflation expectations only on the basis of past data; others instead trust the central bank's objective and use models that better capture the working of the economy. The analysis is accompanied by empirical evidence on the properties of inflation expectations in the euro area. Our results suggest that monetary policy may lose effectiveness if delayed too much, as expectations are allowed to drift away from target for too long. Optimal monetary policies tend to be more hawkish than under rational expectations: the central bank must react more strongly to deviation of inflation from targets, regardless of whether inflation is too high or too low.