Bank of Finland Research Discussion Papers No. 13/2017
This paper studies the formation of inflation expectations in the euro area. We first analyse the forecast accuracy of ECB inflation projections relative to private sector forecasts. Then, using the ECB Survey of Professional Forecasters (ECB SPF), we estimate a general model integrating two theoretical concepts: the hybrid model of expectations, including rational and static expectations, and the sticky-information (epidemiological) model. When modelling inflation expectations we consider – except for backward-looking factors – the rational expectations assumption and the effects of ECB communication. More specifically, we examine whether ECB inflation projections are still important in expectations' formation once the impact of forward-lookingness of economic agents has been taken into account. We also derive implicit (perceived) inflation targets and assess their consistency with the official ECB inflation target. Our analysis indicates that the recent turbulent times have contributed to changes in expectations' formation in the euro area, as the importance of backward-looking mechanisms has decreased, while the importance of the perceived inflation target has increased. We also find that the perceived inflation target has remained broadly consistent with the official ECB inflation target in the medium-term. However, the downward trend of the perceived target suggests some risks of de-anchoring of inflation expectations. The importance of ECB inflation projections for medium-term private sector inflation expectations has increased over time, but the magnitude of this effect is rather small. However, SPF inflation forecasts remain consistent with ECB communication, being either close to ECB projections or between ECB projections and the inflation target.