Inflation: Do Expectations Trump the Gap?
by Jeremy M. Pigera and Robert H. Rascheb
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 obtained from surveys.
JEL Codes: C32, E31.
(PDF, 32 pages 1638 kb)
aUniversity of Oregon
bFederal Reserve Bank of St. Louis