Anchored Inflation Expectations and the Flatter Phillips Curve

Abstract

Conventional versions of the Phillips curve cannot account for inflation dynamics during and after the U.S. Great Recession, leading many to conclude that the Phillips curve relationship has weakened or even disappeared. We show that if agents solve a signal extraction problem to disentangle temporary versus permanent shocks to inflation, then agents’inflation expectations should have become more “anchored”over the Great Moderation period. An estimated New Keynesian Phillips curve that accounts for the increased anchoring of expected inflation exhibits a stable slope coeffi cient over the period 1960 to 2019. Out-of-sample forecasts show that this model can account for the “missing disinflation”during the U.S. Great Recession and the “missing inflation”during the subsequent recovery. We use a simple three-equation New Keynesian model to show that an increase in the Taylor rule coeffi cient on inflation (or the output gap) serves to endogenously anchor agents’subjective inflation expectations and thereby “flatten”the reduced-form Phillips curve.