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Inflation: Do Expectations Trump the Gap?

  • Jeremy M. Piger

    (University of Oregon)

  • Robert H. Rasche

    (Federal Reserve Bank of St. Louis)

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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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. 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.
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