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Irrational Bias in Inflation Forecasts

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  • Kim, Insu
  • Kim, Minsoo
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Abstract

This paper investigates the issue of rational expectations using inflation forecasts from the Survey of Professional Forecasters (SPF) and the Green Book. We provide an alternative test of rational expectations hypothesis by measuring the degree of persistence of potential systematic mistakes. The test is obtained by solving a signal extraction problem that distinguishes between systematic and non-systematic forecast errors. The findings indicate highly persistent systematic mistakes, which are driven by the inefficient use of available information, and reject the rational expectations hypothesis. The estimated time-varying bias can be used to improve the SPF and Green Book inflation forecast performance by at least 13.4%. This paper also documents evidence that the real interest rate plays a crucial role in explaining the level of bias that leads to under- and over predictions of actual inflation.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16447.

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Date of creation: 23 Jul 2009
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Handle: RePEc:pra:mprapa:16447

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Keywords: Inflation Expectations; Bias; Forecasts; Rational Expectations;

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References

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  1. David Andolfatto & Scott Hendry & Kevin Moran, 2007. "Are Inflation Expectations Rational?," Working Paper Series 27-07, The Rimini Centre for Economic Analysis.
  2. 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.
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  4. Laurence Ball & Dean Croushore, 1995. "Expectations and the Effects of Monetary Policy," NBER Working Papers 5344, National Bureau of Economic Research, Inc.
  5. Sbordone, Argia M., 2005. "Do expected future marginal costs drive inflation dynamics?," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1183-1197, September.
  6. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  7. Carlos Capistrán, 2006. "Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious?," Working Papers 2006-14, Banco de México.
  8. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky information versus sticky prices: a proposal to replace the New-Keynesian Phillips curve," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  9. Ben S. Bernanke, 2007. "Inflation expectations and inflation forecasting," Speech 306, Board of Governors of the Federal Reserve System (U.S.).
  10. Lovell, Michael C, 1986. "Tests of the Rational Expectations Hypothesis," American Economic Review, American Economic Association, vol. 76(1), pages 110-24, March.
  11. Rudd, Jeremy & Whelan, Karl, 2005. "Does Labor's Share Drive Inflation?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(2), pages 297-312, April.
  12. Yash P. Mehra, 2002. "Survey measures of expected inflation : revisiting the issues of predictive content and rationality," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 17-36.
  13. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  14. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
  15. Dean Croushore, 1997. "The Livingston Survey: still useful after all these years," Business Review, Federal Reserve Bank of Philadelphia, issue Mar, pages 15-27.
  16. repec:fip:fedgsq:y:2007:i:jul10 is not listed on IDEAS
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Cited by:
  1. Murray, James, 2011. "Learning and judgment shocks in U.S. business cycles," MPRA Paper 29257, University Library of Munich, Germany.

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