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Tale About Inflation Tails

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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.

Suggested Citation

  • Olesya V. Grishchenko & Laura Wilcox, 2024. "Tale About Inflation Tails," Finance and Economics Discussion Series 2024-028, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2024-28
    DOI: 10.17016/FEDS.2024.028
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    Keywords

    Inflation forecasts; Inflation state-space model; Probability of rare inflation events; Inflation anchoring;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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