Academic journal article Economic Perspectives

When Can We Forecast Inflation?

Academic journal article Economic Perspectives

When Can We Forecast Inflation?

Article excerpt

Introduction and summary

The practice of forecasting inflation has generally been considered an important input in monetary policymaking. Recently, this view has come under attack. In an article that appeared in the Federal Reserve Bank of Minneapolis's Quarterly Review, Atkeson and Ohanian (2001, hereafter A&O) argue that the likelihood of accurately predicting a change in inflation using modem inflation forecasting models is no better than a coin flip. They conclude that these forecasting models cannot be considered a useful guide for monetary policy. In this article, we reexamine the findings that underlie this conclusion. We show that it may be possible to forecast inflation over some horizons and in some periods.

A&O study the properties of standard Phillips-curve-based inflation forecasting models. These models relate changes in inflation to past values of the unemployment gap (the difference between unemployment and a measure of unemployment believed to be associated with non-accelerating inflation, the so-called NAIRU [non-accelerating inflation rate of unemployment]), past changes in inflation, and perhaps other variables believed to be useful indicators of inflation. (1) Recently, Stock and Watson (1999, hereafter S&W) proposed a generalized version of the Phillips curve and argued that their generalization is superior to these standard models as a forecasting tool. Focusing on the one-year-ahead forecast horizon, A&O argue that unemployment-based Phillips curve models and S&W generalized Phillips curve models can do no better than a "naive model," which says that inflation over the coming year is expected to be the same as inflation over the past year. This analysis focuses on the ability to forecast the magnit ude of inflation in the Consumer Price Index (total CPI), the CPI less food and energy components (core CPI), and the personal consumption expenditures deflator (total PCE) over the sample period 1985 to 2000.

To gain some insight into these findings, figure 1, panel A displays 12-month changes in 12-month core CPI from 1967 to 2000. The vertical lines in this figure (in 1977, 1985, and 1993) divide the sample period into four periods. It is immediately clear that in the two later periods, that is, the sample period considered by A&O, the volatility of changes in inflation was much lower than in the two earlier periods. This change in the behavior of inflation seems to be coincident with the change in monetary policy regime that is generally thought to have taken effect in the mid-1980s. (2) The lower volatility and the possibility of a changed monetary policy regime in the later two sample periods may favor the naive model studied by A&O. Figure 1, panel B shows that PCE less food and energy components (core PCE) behaves in a similar fashion.

These changes in the behavior of inflation raise the question of whether A&O's findings are due to special features of the data in the sample period they chose to focus on. To address this possibility, we extend the A&O analysis by studying three distinct sample periods, 1977-84, 1985-92, and 1993-2000. In addition, we add core PCE inflation to the list of inflation measures and we consider a broader class of Stock-Watson type models. A&O focus on the one-year forecast horizon. Given the lags inherent in the effects of monetary policy actions, it is reasonable to consider whether their results extend to longer horizons. Consequently, we analyze both the one-year and two-year forecast horizons.

Our findings confirm the A&O results for the 1985-2000 period, but not for 1977-84. The Phillips curve models perform poorly in both the 1985-92 and 1993-2000 periods when forecasting core CPI.

However, when forecasting core PCE, these models improve significantly relative to the naive model in the 1993-2000 period. While the Phillips curve models do poorly for the one-year-ahead forecast horizon, we do find evidence in favor of the Phillips curve models for the two-year-ahead forecast horizon, at least with respect to core inflation. …

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