Deflationary shocks and de-anchoring of inflation expectations

A prolonged period of low inflation, particularly in a situation of monetary policy rates near the zero lower bound, can heighten the risk of inflation expectations de-anchoring from the central bank objective. The purpose of this paper is to assess the effects of a sequence of deflationary shocks, such as those that hit the euro area in 2013-14, on expected/realized inflation and output. To do so we consider a simple New Keynesian model where agents, rather than being endowed with rational expectations, 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 the assumption both of rational expectations and of learning. The main findings are the followings: (i) under learning, price dynamics in 2015-16 is on average 0.6 percentage points lower than in the case of fully rational agents, as inflation expectations are strongly affected by the repeated deflationary shocks; (ii) the learning process implies a (data-driven) de-anchoring of inflation expectations from the central bank target, which would be perceived by economic agents to fall to 0.8% 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.