Nexus between inflation and inflation expectations at the zero lower bound: A tiger by the tail

Abstract

Ultra-low policy rates and zero lower bounds (ZLB) have been major issues for monetary policy formulation. In this context, we investigate the nexus between inflation and inflation expectations. Employing a non-linear ADRL framework on UK and Canadian datasets, we find significant asymmetries in the nexus among inflation and inflation expectations and their determinants, including labour market slack, output gap, oil shocks, fiscal deficit and exchange rates. Heterogeneities are explicit in the short and long-term as well as in the pre-and post-ZLB regimes. Inflation and inflation expectations become more responsive to their determinants as key policy rates approach the ZLB. There is strong evidence of persistence in inflation and inflation expectations in both regimes manifesting the importance of keeping expectations well anchored. Robustness testing with Time-Varying Parameter Vector Auto-Regression and Network Analysis confirms our findings. To mitigate the persistence of a high inflation regime, it would be vital to keep the inflation expectations well anchored.