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

  • Athanasios Orphanides and Simon van Norden

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.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 247.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:247
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