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Working Paper 2006-013B

"Inflation: Do Expectations Trump the Gap?"
by Jeremy M. Piger, and 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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Category > Monetary Policy/Macroeconomics
Author > Robert H. Rasche
Research Papers and Publications: JEL Code > C32
Research Papers and Publications: JEL Code > E31