Implications of the permanent-transitory confusion for New-Keynesian modeling, inflation forecasts and the post-crisis era

Decisions about consumption, work, leisure, pricing, investment and other private and public policy decisions rely on forecasts of the future. The permanent-transitory confusion (PTC) refers to the fact that even when they know all past and current information individuals are uncertain about the persistence of the current state. This all pervasive informational limitation makes it optimal, in general, to use all past information when forecasting the future even under rational expectations. The objective of this paper is to remind the profession of this basic fact and point out some of its implications by showing at both the theoretical and the empirical levels that forecasts of the future are generally adaptive in the sense that they depend on available past information even when information is utilized efficiently. This is done along the following dimensions. First by briefly surveying the literature on rational-adaptive expectations from Muth (1960) to Coibion-Gorodnichenko (2015). Second, by showing that the PTC injects the past even into purely forward looking New-Keynesian such as that of Clarida, Gali & Gertler (1999). Third, by showing empirically that inflationary expectations in the US Survey of Professional Forecasters rely on past inflation. The paper concludes with reflections on the persistence of economic and policy changes induced by the global financial crisis.