Inflation Expectations and Term Premium

Over the past decades, returns on the long-term financial assets as well as the long-run inflation expectations were persistently falling. Moreover, the natural rate was in decline dropping significantly in 2008. We build a model capable to replicate these empirical facts to study the role of such persistent variables and the relationship between them. We find that a persistent decline in the perceived inflation target can push both the long-run inflation and the term premium down. We show that replicating a positive correlation between long-run inflation and term premium, that we observe in the data, requires the setup of imperfect information when economic agents need time to recognize persistent shocks and adjust their expectations. We use the model to explain persistently low financial indicators in the aftermath of the Great Recession