09.03.2018

Working Paper no. 77: Disinflation and improved anchoring of long-term inflation expectations: The Icelandic experience

Working Paper 77

The Central Bank of Iceland has published a new working paper on the interaction between the recent development of inflation and the improved anchoring of long-term inflation expectations at the Central Bank’s inflation target.

The paper discusses the importance of improved anchoring of long-term inflation expectations in explaining why inflation has been low and stable in recent years despite a significant cyclical recovery. Estimation of a forward-looking Phillips curve suggests a structural shift in the average relation between inflation and its key drivers occurring around 2012 and non-linear estimation methods suggest that it reflects a more rapid decline in long-term inflation expectations than is captured by measures of inflation expectations in financial markets. Together with the large decline in imported inflation, the improved anchoring of long-term inflation expectations goes a long way towards explaining the large disinflation since 2012. It also seems that an important part of the persistent over-prediction of inflation in Iceland by most forecasters in recent years can be explained by the failure to take the gradual improvement in monetary policy credibility since 2012 into account. Finally, this combination of imported deflation and a firmer anchoring of inflation expectations can explain why the post-2012 disinflation episode did not coincide with any loss of output.

The working paper can be accessed here: Disinflation and improved anchoring of long-term inflation expectations: The Icelandic experience by Thórarinn G. Pétursson.

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