Asymmetry in inflation persistence under inflation targeting

Abstract

This study empirically documents that inflation is significantly more persistent when it is below the Central Bank’s target than otherwise, in five inflation targeting countries (Australia, New Zealand, Sweden, United States and the Euro-Area). We use a threshold autoregressive model to test for this asymmetry in inflation persistence; above and below some estimated threshold. We find that the threshold estimates are reasonable in light of a central bank’s announced inflation target. Theoretically, we postulate that this phenomenon occurs because while forming their expectations, agents pay attention to recent observations asymmetrically along the business cycle. It is shown that a New Keynesian model with adaptive learning and an adaptive gain can explain the asymmetry in inflation persistence. Due to relatively larger forecasting errors, agents tend to put more weight on recent events in periods of high inflation, forcing inflation persistence to deteriorate. Our empirical evidence supports the theoretical findings that inflationary periods are associated with larger forecasting errors.