Monetary policy, de-anchoring of inflation expectations, and the “new normal”

Persistently low inflation rates, followed by declining inflation expectations, in advanced economies after the Great Recession have raised the question whether central banks are still able to credibly anchor inflation to their medium-term targets. The purpose of this paper is twofold. First, we investigate why agents’ expectations that over the business cycle inflation will remain in line with the target begin to falter. Our hypothesis is that agents form expectations in terms of their probabilistic belief that the economy may switch from a normal to a depression state (permanently low output and inflation), which is updated upon observing the actual state of the economy. Second, we study how the de-anchoring of expectations interacts with monetary policy to determine whether the central bank is still able to achieve its target - and hence re-anchor inflation expectations - or whether the system drifts towards depressed states. We obtain two main findings. The first is that, facing unfavourable shocks, if inflation expectations ``fall faster" than the policy rate, and the zero lower bound is reached without correcting the shock, the system converges to a new steady state - the "new normal" - with permanent negative gaps. The second is that a more aggressive monetary policy is ineffective both at the zero lower bound and above it, when the shock is large and/or when the reactivity of inflation expectations is sufficiently high. This latter finding seems to support the necessity, in those conditions, to abandon conventional monetary policy and to switch to an aggressive reflationary policy package that prevents the entrenchment of deflationary expectations.