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Inflation: do expectations trump the gap?

  • Jeremy M. Piger
  • Robert H. Rasche

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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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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  1. GlennD. Rudebusch & Tao Wu, 2008. "A Macro-Finance Model of the Term Structure, Monetary Policy and the Economy," Economic Journal, Royal Economic Society, vol. 118(530), pages 906-926, 07.
  2. Andrew T. Levin & Jeremy M. Piger, 2003. "Is inflation persistence intrinsic in industrial economies?," Working Papers 2002-023, Federal Reserve Bank of St. Louis.
  3. 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.
  4. Clark, Todd E. & McCracken, Michael W., 2006. "The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1127-1148, August.
  5. 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.
  6. 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.
  7. Athanasios Orphanides & Simon van Norden, 2004. "The reliability of inflation forecasts based on output gap estimates in real time," Finance and Economics Discussion Series 2004-68, Board of Governors of the Federal Reserve System (U.S.).
  8. Robert J. Gordon, 1996. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  9. Robert J. Gordon, 1981. "Inflation, Flexible Exchange Rates, and the Natural Rate of Unemployment," NBER Working Papers 0708, National Bureau of Economic Research, Inc.
  10. 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.
  11. 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.
  12. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 293-335, October.
  13. 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.
  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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