Working Paper no. 81: Long-term inflation expectations and inflation dynamics
The Central Bank of Iceland has published a new working paper on the interaction between inflation and long-term inflation expectations at the Central Bank’s inflation target. This paper is a revised and updated version of Working Paper No. 77 that was published in March 2018.
The paper discusses the role of declining long-term inflation expectations in inflation dynamics in Iceland in recent years and the importance of measuring these expectations correctly. Estimation of a forward-looking Phillips curve suggests a structural shift in the average relation between inflation and its key drivers occurring around 2012. Non-linear estimation methods suggest that this can be explained by taking into account the difference between expectations of price setters and those observed in financial markets, in addition to correcting for the developments of risk premia imbedded into bond yields. Once this is done, a stable Phillips curve that can explain the decline in inflation since 2012 and why inflation has remained stable despite a strong cyclical recovery.
Dataset: Datafile for the paper