Japanese and U.S. Inflation Dynamics in the 21st Century

This paper examines the behavior of inflation in the U.S. and Japan over the past twenty-five years. The paper estimates structural models of inflation dynamics for both countries, relying on survey measures as proxies for expectations. The results suggest some promising directions for inflation modeling in both countries. First, the use of survey expectations as proxies for the expectations in conventional models appears to be helpful, aiding in identification of the inflation process in both countries. Second, methods for endogenizing such expectations are tractable and replicable. They require the measurement of longer-term expectations, but such data are available for many key variables in many developed economies. Third, models that incorporate such expectations identify a rationale for the behavior of US and Japanese inflation: a. Long-run expectations anchor the process, although long-run expectations can be influenced over time by persistent deviations of inflation (or output) from their long-run equilibria; b. Short-run expectations are tied to their long-run counterparts, but they can deviate quite persistently from long-run expectations, due to persistent deviations of output from potential, and due to intrinsic persistence in the expectations; c. Inflation appears well-explained by short-run expectations and a traditional output gap; Fourth, the balance sheet actions in Japan appear to have boosted short-run inflation expectations, compared to where they would have been without such actions. The estimates in this paper suggest that this in turn has helped to raise realized inflation by about one-half percentage point.