Working Paper

Tale About Inflation Tails

Abstract: We study probabilities of extreme inflation events in the Unites States and the euro area. Using a state-space model that incorporates information from a large set of professional forecasters, we generate the term structure of inflation forecasts as well as probabilities of future inflation for any range of inflation outcomes in closed form at any horizon. Since the onset of the COVID-19 pandemic, inflation expectations increased materially amid heightened uncertainty about future inflation. Likelihood of significant departures of inflation targets in the longer term reached about 15 percent in the middle of 2022, increasing from near zero levels in 2020. Such an increase in the right tail of the probability distribution over future inflation outcomes drives an increase in inflation expectations and inflation risk premiums. Several popular external uncertainty measures are associated with variation in tail probabilities.

Keywords: Inflation forecasts; Inflation state-space model; Probability of rare inflation events; Inflation anchoring;

JEL Classification: G12; G13; G14;

https://doi.org/10.17016/FEDS.2024.028

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2024-05-08

Number: 2024-028