Economics Seminar-"What (De)-Anchors Inflation Expectations?"

What (de-)anchors inflation expectations? This paper studies the long-run dynamics of inflation expectations by modeling the entire expected inflation term structure as a single curve valued (functional) time series. We document persistent low-frequency movements across maturities that are inconsistent with stationarity at the functional level. Motivated by this evidence, we model the term structure as a functional autoregressive process with a unit root and decompose innovations into permanent and transitory components using long-run restrictions in the spirit of Blanchard and Quah, adapted to a functional setting. Empirically, we find that long-horizon inflation expectations are driven exclusively by permanent shocks: transitory disturbances have no effect at the far end of the curve. Permanent shocks therefore represent belief re-anchoring episodes that shift the long-run inflation anchor, while transitory shocks generate short-lived deviations. Although both shocks have similar short-run effects on inflation and real activity when normalized by their impact on inflation, monetary policy responds more strongly and persistently to permanent shifts in expectations. Large permanent shocks coincide with episodes widely interpreted as shifts in the inflation regime or in monetary policy credibility. Moreover, permanent shocks are positively correlated with monetary policy and oil supply surprises, reinforcing their interpretation as belief re-anchoring disturbances. Taken together, the evidence suggests that inflation expectations are anchored by monetary policy credibility and de-anchored by shocks that alter perceptions of the inflation regime, rather than by conventional cyclical demand fluctuations.