A Microfounded Mechanism of Observed Substantial Inflation Persistence

Recently, it has been argued that trend inflation may be the solution to the puzzle of inflation persistence in the New Keynesian Phillips curve (NKPC). However, incorporating trend inflation into the NKPC raises another serious problem—it lacks a microfoundation. The paper presents a microfoundation for trend inflation, which indicates that trend inflation is a natural consequence of simultaneous optimization by the government and households. A purely forward-looking model is constructed based on the microfoundation presented. The model enables a unified explanation for various types of inflation. It also indicates that, if inflation is assumed to follow an autoregressive process without considering trend inflation, many measures of inflation persistence will spuriously indicate that inflation is intrinsically substantially persistent and has a backward-looking property.