Inflation expectations and regime shifts in the euro area

Abstract

This paper focuses on the determination of inflation expectations. The following two questions are exam-ined: How much do inflation expectations reflect different economic and institutional regime shifts and in which way do inflation expectations adjust to past inflation? The basic idea in the analysis is an assump-tion that inflation expectations do not mechanically reflect past inflation as may econometric specification de facto assume but rather they depend on the relevant economic regime. Also the adjustment of expecta-tions to past inflation is different in different inflation regimes. The regime analysis is based on panel data from EMU/EU countries for the period 1973–2004, while the inflation adjustment analysis mainly uses the Kalman filter technique for individual countries for the same period. Expectations (forecasts) are de-rived from OECD data. Empirical results strongly favour the regime-sensitivity hypothesis and provide an explanation for the poor performance of conventional estimation procedures in the context of Phillips curves.inflation expectations; Kalman filter; stability