Predictive Abilities of Inflation Expectations and Implications on Monetary Policy in Korea

This paper examines the predictive abilities of various inflation expectation indicators for inflation in Korea. We conducted real-time out-of-sample forecasting experiments utilizing three inflation expectation indicators – the general public’s expectation, professional forecasters’ expectation, and break-even inflation (BEI). The results can be summarized as follows: (i) BEI is at least as useful as the other expectation indicators in forecasting inflation; (ii) regression-based models using industrial production, oil price, and exchange rate do not help out-of-sample inflation forecasting in general; (iii) the policy interest rate, in contrast, can significantly reduce the forecasting errors; and (iv) a one percent-point increase in the policy interest rate is estimated to suppress inflation for the subsequent 12 months by around one percent-point. These results suggest that monetary policy is effective for controlling inflation and a simple model using the policy interest rate and an inflation expectation indicator may be preferred for inflation forecasting.