Inflation: Do Expectations Trump the Gap?
FRB of St. Louis Working Paper No. 2006-013B
49 Pages Posted: 16 Apr 2006
Date Written: July 2006
Abstract
We measure the relative contribution of the deviation of real activity from its equilibrium (the gap), "supply shock" variables, and long-horizon inflation expectations 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 expectations dominates that for the gap and supply shock variables. Put another way, variation in long-horizon inflation expectations explains the bulk of the movement in realized inflation. We also 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 those observed from surveys.
Keywords: Inflation persistence, Inflation forecast, Phillips Curve
JEL Classification: C32, E31
Suggested Citation: Suggested Citation
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