From Volcker to the Pandemic Era: History Dependent Anchoring of Short-Run Expected Inflation

We develop an endogenous measure of anchoring for short-run expected inflation in a New Keynesian model with full-information rational expectations. Specifically, we allow the fraction of non-reoptimizing firms that index prices to the inflation target, rather than lagged inflation, to depend on observed inflation persistence. The model with endogenous indexation generates a scatter plot of persistence and volatility measures for inflation that approximates the convex pattern observed in quarterly U.S. data. With endogenous indexation, the equilibrium anchoring measure exhibits history dependence. To illustrate this idea, we perform a series of disinflation simulations where the model inflation target declines to 2% at different speeds, starting from around 8% in 1980.Q1. The Volcker disinflation simulation exactly replicates the U.S. data using the model-implied anchoring measure and model-implied shock sequences. We show that a slower disinflation mitigates output losses but results in a weaker anchoring measure over subsequent decades. The Volcker disinflation produces a more severe recession in 1982 but leads to a stronger anchoring measure that renders inflation more resilient to subsequent shocks, such as those that arrive during the Great Recession and the pandemic era.