Monetary Policy, De-Anchoring of Inflation Expectations, and the 'New Normal'

Abstract

Low inflation rates in the Euro Area raise the question of whether inflation is still credibly anchored to the Euro-system’s medium term target of below, but close to 2%. The purpose of this paper is twofold. On the one hand, we investigate why agents’ inflation expectations that inflation will remain in line with the target begin to falter. On the other hand, we want to study how the de-anchoring of expectations interacts with monetary policy determining whether the central bank is still able to achieve its target - and hence re-anchor inflation expectations - or whether the system drifts away towards the liquidity trap. Two are our main findings. The first is that large unfavourable shocks might lead agents to question their trust in resilience of the system, and to revise their expectations. If inflation expectations fall faster than the policy rate, and the zero lower bound is reached without correcting the interest-rate gap, 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 ZLB and above the ZLB, when the shock is large shocks and/or when the reactivity of inflation expectations is high enough. This last finding seems to support the necessity, in those conditions, to abandon conventional monetary policy and to switch to an aggressive reflationary policy that prevents the entrenchment of deflationary expectations.