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The Reliability of Inflation Forecasts Based on Output Gaps in Real Time

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  • Athanasios Orphanides and Simon van Norden

Abstract

A stable predictive relationship between inflation and the output gap, often referred to as a Phillips curve, provides the basis for empirical formulations of countercyclical monetary policy in many models. However, evidence for the usefulness of output gap measures for forecasting inflation is often based on data that are not available when actual forecasts are made in practice. This ignores difficulties associated with estimation of the output gap in real-time and raises questions regarding the reliability of the resulting forecasts. In this paper we evaluate alternative multivariate methods for estimation of the output gap and assess their usefulness for predicting inflation. Our results suggest that inference based on ex-post constructed output gap measures severely overstates their usefulness for predicting inflation and, therefore, for the real-time policy process. Further, forecasts based on models that fail to control for the unreliability of the real-time estimates of the output gap are often less accurate than forecasts that abstract from the output gap concept altogether. These results bring into question the reliability of inflation forecasts based on output gaps for formulating monetary policy.

Suggested Citation

  • Athanasios Orphanides and Simon van Norden, 2001. "The Reliability of Inflation Forecasts Based on Output Gaps in Real Time," Computing in Economics and Finance 2001 247, Society for Computational Economics.
  • Handle: RePEc:sce:scecf1:247
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    Citations

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    Cited by:

    1. Harrison, Richard & Kapetanios, George & Yates, Tony, 2005. "Forecasting with measurement errors in dynamic models," International Journal of Forecasting, Elsevier, vol. 21(3), pages 595-607.
    2. Ciccarelli, Matteo & Altavilla, Carlo, 2007. "Information combination and forecast (st)ability evidence from vintages of time-series data," Working Paper Series 846, European Central Bank.
    3. Alberto Musso & Livio Stracca & Dick van Dijk, 2009. "Instability and Nonlinearity in the Euro-Area Phillips Curve," International Journal of Central Banking, International Journal of Central Banking, vol. 5(2), pages 181-212, June.
    4. Clements, Michael P & Galvão, Ana Beatriz, 2006. "Macroeconomic Forecasting with Mixed Frequency Data : Forecasting US output growth and inflation," The Warwick Economics Research Paper Series (TWERPS) 773, University of Warwick, Department of Economics.
    5. Lindsey, David E. & Orphanides, Athanasios & Rasche, Robert H., 2013. "The Reform of October 1979: How It Happened and Why," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 487-542.
    6. Clements, Michael P. & Beatriz Galvão, Ana, 2010. "First announcements and real economic activity," European Economic Review, Elsevier, vol. 54(6), pages 803-817, August.
    7. Michael P. Clements & Ana Beatriz Galvão, 2007. "Macroeconomic Forecasting with Mixed Frequency Data: Forecasting US Output Growth," Working Papers 616, Queen Mary University of London, School of Economics and Finance.

    More about this item

    Keywords

    Real-time data; business cycle measurement; inflation;

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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