Extrapolative Inflation Expectations and the Eurozone Missing Inflation Puzzle

Abstract

This paper proposes a solution to the post-crisis Eurozone missing puzzle. I demonstrate that following an initially subdued inflation, economic agents started to forecast inflation by extrapolating past inflation developments as opposed to utilizing a purely forward-looking model. I show that such a shift aggravated the decline of actual inflation through a self-fullling, deflationary spiral jointly involving actual and expected inflation. Using market-implied inflation expectations extracted from inflation derivatives between 2009 and 2016, I provide evidence in favor of the extrapolative nature of these expectations, and incorporate them within the New Keynesian framework, resulting in an extrapolative New Keynesian Phillips curve. An empirical estimation of this augmented curve confirms the need to incorporate such expectations within the baseline framework in order to describe the post-crisis dynamics of inflation in the Eurozone. Subsequently, I show that the inflation inertia created by the backward-looking nature of the extrapolative expectations counteracted the reflationary impact created by the accommodative monetary policy within the Eurozone economy. The presence of such expectations, therefore, allowed a deflationary shock to have long-lasting effects on both expected and actual inflation. The results of this paper also shed light on the recent policy debate that has sought to understand the chronically low inflation among some advanced economies despite strengthening growth.