Asymmetry in Inflation Rates Under Inflation Targeting

Abstract

This study empirically documents that inflation is significantly more persistent when it is below the central bank target than otherwise, for inflation rates in five inflation targeting countries (Australia, New Zealand, Sweden, United States and the Euro- Area). The study uses a threshold autoregressive (TAR) model to test for asymmetry in inflation persistence; above and below some estimated threshold. It documents that the threshold estimates are reasonable in light of a central bank's announced inflation target. We postulate that the phenomenon occurs because while forming their expectations, agents pay attention to recent observations asymmetrically along the business cycle. It is demonstrated theoretically that a New Keynesian model with adaptive learning and also an adaptive gain can explain the asymmetry in persistence. Due to relatively larger forecasting errors, agents tend to put more weigh on recent events in expansions, forcing inflation persistence to deteriorate. Empirical evidence from this study supports the theoretical findings that inflationary periods are associated with larger forecasting errors.