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Inflation: Do Expectations Trump the Gap?

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  • Jeremy M. Piger

    (University of Oregon)

  • Robert H. Rasche

    (Federal Reserve Bank of St. Louis)

Abstract

We measure the relative contribution of the deviation of real activity from its equilibrium (the gap), “supply-shock” variables, and long-horizon inflation forecasts for explaining the U.S. inflation rate in the post-war period. For alternative specifications for the inflation-driving process and measures of inflation and the gap, we reach a similar conclusion: the contribution of changes in long-horizon inflation forecasts dominates that for the gap and supply-shock variables. Put another way, variation in long-horizon inflation forecasts explains the bulk of the movement in realized inflation. Further, we find evidence that long-horizon forecasts have become substantially less volatile over the sample period, suggesting that permanent shocks to the inflation rate have moderated. Finally, we use our preferred specification for the inflation-driving process to compute a history of model-based forecasts of the inflation rate. For both short and long horizons, these forecasts are close to inflation expectations obtained from surveys.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 4 (2008)
Issue (Month): 4 (December)
Pages: 85-116

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Handle: RePEc:ijc:ijcjou:y:2008:q:4:a:3

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  1. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 293-335, October.
  2. Todd E. Clark & Michael W. McCracken, 2003. "The predictive content of the output gap for inflation : resolving in-sample and out-of-sample evidence," Research Working Paper RWP 03-06, Federal Reserve Bank of Kansas City.
  3. Orphanides, Athanasios & van Norden, Simon, 2005. "The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(3), pages 583-601, June.
  4. Refet S. Gürkaynak & Brian Sack & Eric Swanson, 2005. "The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models," American Economic Review, American Economic Association, vol. 95(1), pages 425-436, March.
  5. Margaret M. McConnell & Gabriel Perez Quiros, 1997. "Output fluctuations in the United States: what has changed since the early 1980s?," Research Paper 9735, Federal Reserve Bank of New York.
  6. Glenn Rudebusch & Tao Wu, 2004. "A macro-finance model of the term structure, monetary policy, and the economy," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  7. Charles R. Nelson, 2000. "Output fluctuations in the United States: what has changed since the early 1980s? comments," Proceedings, Federal Reserve Bank of San Francisco.
  8. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  9. Robert J. Gordon, 1997. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  10. Andrew T. Levin & Jeremy M. Piger, 2003. "Is inflation persistence intrinsic in industrial economies?," Working Papers 2002-023, Federal Reserve Bank of St. Louis.
  11. Kozicki, Sharon & Hoffman, Barak, 2004. "Rounding Error: A Distorting Influence on Index Data," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 319-38, June.
  12. Robert J. Gordon, 1982. "Inflation, Flexible Exchange Rates, and the Natural Rate of Unemployment," NBER Working Papers 0708, National Bureau of Economic Research, Inc.
  13. Andrew Atkeson & Lee E. Ohanian., 2001. "Are Phillips curves useful for forecasting inflation?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-11.
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Cited by:
  1. Alberto Musso & Livio Stracca & Dick van Dijk, 2009. "Instability and Nonlinearity in the Euro-Area Phillips Curve," International Journal of Central Banking, International Journal of Central Banking, vol. 5(2), pages 181-212, June.
  2. Kevin J. Lansing, 2006. "Time-varying U.S. inflation dynamics and the New-Keynesian Phillips curve," Working Paper Series 2006-15, Federal Reserve Bank of San Francisco.
  3. John A. Tatom, 2013. "Globalization and Inflation: A Swiss Perspective," NFI Working Papers 2013-WP-02, Indiana State University, Scott College of Business, Networks Financial Institute.
  4. Daniel L. Thornton, 2008. "Monetary policy: why money matters and interest rates don't," Working Papers 2008-011, Federal Reserve Bank of St. Louis.
  5. Kitov, Oleg & Kitov, Ivan, 2011. "A win-win monetary policy in Canada," MPRA Paper 29975, University Library of Munich, Germany.
  6. Kitov, Ivan, 2009. "The anti-Phillips curve," MPRA Paper 13641, University Library of Munich, Germany.
  7. Todd E. Clark & Troy Davig, 2008. "An empirical assessment of the relationships among inflation and short- and long-term expectations," Research Working Paper RWP 08-05, Federal Reserve Bank of Kansas City.
  8. Kevin L. Kliesen, 2010. "Inflation may be the next dragon to slay," The Regional Economist, Federal Reserve Bank of St. Louis, issue Jan, pages 4-9.

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