According to both central bankers and economic theory, anchored inflation expectations are key to successful monetary policymaking. Yet, we know very little about the determinants of those expectations. While policymakers may take some comfort in the stability of long-run inflation expectations, the latter is not an inherent feature of the economy. What does it take for expectations to become unanchored? We explore a theory of expectations formation that can produce episodes of unanchoring. Its key feature is state-dependency in the sensitivity of long-run inflation expectations to short-run inflation surprises. Price-setting agents act as econometricians trying to learn about average long-run inflation. They set prices according to their views about future inflation, which hence feed back into actual inflation. When expectations are anchored, agents believe there is a constant long-run inflation rate, which they try to learn about. Hence, their estimates of long-run inflation move slowly, as they keep adding observations to the sample they consider. However, in the spirit of Marcet and Nicolini (2003), a long enough sequence of inflation suprises leads agents to doubt the constancy of long-run inflation, and switch to putting more weight on recent developments. As a result, long-run inflation expectations become unanchored, and start to react more strongly to short-run inflation surprises. Shifts in agents’ views about long-run inflation feed into their price-setting decisions, imparting a drift to actual inflation. Hence, actual inflation can show persistent swings away from its long-run mean. We estimate the model using actual inflation data, and only short-run inflation forecasts from surveys. The estimated model produces long-run forecasts that track survey measures extremely well. The estimated model has several uses: 1) It can tell a story of how inflation expectations got unhinged in the 1970s; it can also be used to construct a counterfactual history of inflation under anchored long-run expectations. 2) At any given point in time, it can be used to compute the probability of inflation or deflation scares. 3) If embedded into an environment with explicit monetary policy, it can also be used to study the role of policy in shaping the expectations formation mechanism.

Co-authors: Carlos Carvalho, Stefano Eusepi and Bruce Preston