| Summary: | After rising sharply following the Global Financial Crisis, inflation in Iceland has been low and stable in recent years despite a strong cyclical recovery. This not only reflects favourable external conditions but also coincides with a significant decline in long-term inflation expectations in financial markets. It is argued, however, that this market-based measure of inflation expectations actually underestimates the true decline in long-term inflation expectations of price setters. To extract this unobserved wedge between inflation expectations of price setters and financial agents, we estimate a time-varying parameter Phillips curve model for the inflation-targeting period since 2001, adjusting also for an unobserved risk premium in market-based inflation expectations. The empirical results suggest that the expectations wedge was significantly positive until early 2012, after which it starts to gradually decline towards zero. The true decline in long-term inflation expectations of actual price setters is therefore much steeper than is captured by the market-based measure and taking this into account results in a stable and plausible specification of the Phillips curve that can explain key features of the recent inflation developments in Iceland.
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