Disinflation and improved anchoring of long-term inflation expectations - The Icelandic experience

After rising sharply following the Global Financial Crisis, inflation in Iceland has been low and stable in recent years despite a strong cyclical recovery. This not only reflects good luck – stemming from low global inflation, declining commodity prices, and a currency appreciation – but also a significant improvement in monetary policy credibility as reflected in a large decline in long-term inflation expectations. To quantify these effects, a forward-looking, open-economy Phillips curve is estimated for the inflation-targeting period since 2001. The empirical results suggest a structural shift in the average relation between inflation and its key drivers occurring around 2012. It is argued that this reflects the convergence of long-term inflation expectations of households and firms towards the downward trending inflation expectations in financial markets. Long-term inflation expectations of households and firms are not observed, but using a Markov switching model and a time-varying parameter model suggests that this unobserved component of long-term inflation expectations has declined from an average of about 2 percentage points in 2003-2011 to zero in late 2016. Together with the large decline in imported inflation, the improved anchoring of long-term inflation expectations goes a long way towards explaining the large disinflation of the last five years and the low recent inflation despite the strong pickup in economic activity. It also seems that an important part of the persistent over-prediction of inflation in Iceland by most forecasters in recent years can be explained by the failure to take the gradual improvement in monetary policy credibility since 2012 into account. Finally, this combination of imported deflation and a firmer anchoring of inflation expectations can explain why the post-2012 disinflation episode did not coincide with any loss of output.