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Inflation: do expectations trump the gap?

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  • Jeremy M. Piger
  • Robert H. Rasche

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 in surveys and market data.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-013.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2006-013

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Keywords: Government securities ; Inflation (Finance);

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References

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  1. 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.
  2. Michael W. McCracken & Todd E. Clark, 2003. "The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence," Computing in Economics and Finance 2003 183, Society for Computational Economics.
  3. 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.
  4. Athanasios Orphanides & Simon van Norden, 2003. "The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time," CIRANO Working Papers 2003s-01, CIRANO.
  5. Andrew T. Levin & Jeremy M. Piger, 2003. "Is inflation persistence intrinsic in industrial economies?," Working Papers 2002-023, Federal Reserve Bank of St. Louis.
  6. Gordon, Robert J, 1996. "The Time-varying NAIRU and its Implications for Economic Policy," CEPR Discussion Papers 1492, C.E.P.R. Discussion Papers.
  7. Robert J. Gordon, 1981. "Inflation, Flexible Exchange Rates, and the Natural Rate of Unemployment," NBER Working Papers 0708, National Bureau of Economic Research, Inc.
  8. James H. Stock & Mark W. Watson, 1999. "Forecasting Inflation," NBER Working Papers 7023, National Bureau of Economic Research, Inc.
  9. Chang-Jin Kim & Charles R. Nelson, 1999. "Has The U.S. Economy Become More Stable? A Bayesian Approach Based On A Markov-Switching Model Of The Business Cycle," The Review of Economics and Statistics, MIT Press, vol. 81(4), pages 608-616, November.
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. 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. 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.
  2. Daniel L. Thornton, 2012. "Monetary policy: why money matters, and interest rates don’t," Working Papers 2012-020, Federal Reserve Bank of St. Louis.
  3. Oleg Kitov & Ivan Kitov, 2011. "A win-win monetary policy in Canada," Papers 1103.5994, arXiv.org.
  4. Musso, Alberto & Stracca, Livio & van Dijk, Dick, 2007. "Instability and nonlinearity in the euro area Phillips curve," Working Paper Series 0811, European Central Bank.
  5. 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.
  6. 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.
  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. Kitov, Ivan, 2009. "The anti-Phillips curve," MPRA Paper 13641, University Library of Munich, Germany.

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