The NAIRU Under Anchored Inflation Expectations

Abstract

The introduction of inflation targeting has seen long-term inflation expectations become much more anchored than when models of the non-accelerating inflation rate of unemployment (NAIRU) were conceived. This changes how we should interpret the NAIRU and inflation dynamics over the short-to-medium term. We update the model in Cusbert (2017) to allow for structural breaks upon the introduction of inflation targeting in Australia, finding long-term expectations have become relatively more important for inflation dynamics, and inflation has become less volatile. We use the model to conduct scenarios that highlight the importance of expectations formation for short-to-medium run inflation dynamics. The scenarios illustrate how anchored inflation expectations improve the short-run trade-off between inflation and unemployment and change inference about the NAIRU – observing falling inflation or wage growth cannot be used to infer that unemployment is above the NAIRU.