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Testing for Explosive Behaviour in Relative Inflation Measures: Implications for Monetary Policy

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  • Vipin Arora
  • Pedro Gomis-Porqueras
  • Shuping Shi

Abstract

In this paper we test for large deviations in headline measures of the price level relative to core measures using the recently proposed test of Phillips et al. (2011a). We find evidence of explosive behaviour in the headline price index of personal consumption expenditures (PCE) relative to the core PCE (less food and energy prices) on three occasions from 1982-2010. Two of these episodes correspond to energy supply shocks (OPEC price collapse of 1986 and Hurricane Katrina). The third one is during March 2008 through September 2008 which seems to be driven by both food and energy prices as these indices exhibit explosive behaviour. We also find evidence suggesting that inflation expectations behave differently under normal and explosive periods. In particular, unemployment and interest rates also help predict inflation expectations during explosive episodes relative to normal times. Furthermore, explosive episodes in the relative measure between headline and core inflation is found to be more important than the relative volatile periods implied by a Markov-switching model when studying inflation expectations. The findings of this paper suggest that explosive behaviour of headline versus core PCE should be taken into account when conducting monetary policy as it is a key determinant in consumers’ inflation expectations.

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Bibliographic Info

Paper provided by Monash University, Department of Economics in its series Monash Economics Working Papers with number 37-11.

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Length: 14 pages
Date of creation: Dec 2011
Date of revision:
Handle: RePEc:mos:moswps:2011-37

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Keywords: Explosive behaviour; core inflation; relative measure; inflation expectations;

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References

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  1. Bharat Trehan, 2011. "Household inflation expectations and the price of oil: it's déjà vu all over again," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue may23.
  2. Shu-ping Shi & Vipin Arora, 2011. "An Application Of Models Of Speculative Behaviour To Oil Prices," CAMA Working Papers 2011-11, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  3. Engemann, Kristie & Owyang, Michael T. & Wall, Howard J., 2011. "Where is an oil shock?," MPRA Paper 31383, University Library of Munich, Germany.
  4. Peter C.B. Phillips & Shu-Ping Shi & Jun Yu, 2012. "Testing for Multiple Bubbles," Cowles Foundation Discussion Papers 1843, Cowles Foundation for Research in Economics, Yale University.
  5. Dwight R. Sanders & Scott H. Irwin, 2010. "A speculative bubble in commodity futures prices? Cross-sectional evidence," Agricultural Economics, International Association of Agricultural Economists, vol. 41(1), pages 25-32, 01.
  6. Bodenstein, Martin & Erceg, Christopher J. & Guerrieri, Luca, 2008. "Optimal monetary policy with distinct core and headline inflation rates," Journal of Monetary Economics, Elsevier, vol. 55(Supplemen), pages S18-S33, October.
  7. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," NBER Working Papers 8290, National Bureau of Economic Research, Inc.
  8. Peter C. B. Phillips & Yangru Wu & Jun Yu, 2011. "EXPLOSIVE BEHAVIOR IN THE 1990s NASDAQ: WHEN DID EXUBERANCE ESCALATE ASSET VALUES?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 52(1), pages 201-226, 02.
  9. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 1-22.
  10. Peter C.B.Phillips & Jun Yu, 2009. "Dating the Timeline of Financial Bubbles During the Subprime Crisis," Working Papers CoFie-07-2009, Sim Kee Boon Institute for Financial Economics.
  11. N. Gregory Mankiw & Ricardo Reis & Justin Wolfers, 2003. "Disagreement about Inflation Expectations," Harvard Institute of Economic Research Working Papers 2011, Harvard - Institute of Economic Research.
  12. Daniel L. Thornton, 2007. "Measure for measure: headline versus core inflation," Monetary Trends, Federal Reserve Bank of St. Louis, issue Sep.
  13. James Bullard, 2011. "Measuring inflation: the core is rotten," Speech 180, Federal Reserve Bank of St. Louis.
  14. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  15. Chu, Chia-Shang James & Stinchcombe, Maxwell & White, Halbert, 1996. "Monitoring Structural Change," Econometrica, Econometric Society, vol. 64(5), pages 1045-65, September.
  16. Daniel L. Thornton, 2011. "Core versus headline inflation: an opportunity for greater transparency," Economic Synopses, Federal Reserve Bank of St. Louis.
  17. Ben S. Bernanke, 2007. "Inflation expectations and inflation forecasting," Speech 306, Board of Governors of the Federal Reserve System (U.S.).
  18. Shu-Ping Shi, 2010. "Bubbles or Volatility: A Markov-Switching Unit Root Test with Regime-Varying Error Variance," ANU Working Papers in Economics and Econometrics 2010-524, Australian National University, College of Business and Economics, School of Economics.
  19. repec:fip:fedgsq:y:2007:i:jul10 is not listed on IDEAS
  20. Hamilton, James D, 1991. "A Quasi-Bayesian Approach to Estimating Parameters for Mixtures of Normal Distributions," Journal of Business & Economic Statistics, American Statistical Association, vol. 9(1), pages 27-39, January.
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