The Predictive Performance of Fundamental Inflation Concepts: An Application to the Euro Area and the United States

Stephen McKnight, Alexander Mihailov (), Kerry Patterson () and Fabio Rumler
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Kerry Patterson: Department of Economics, University of Reading

No em-dp2014-03, Economics Discussion Papers from Department of Economics, University of Reading

Abstract: Does theory aid inflation forecasting? To date, the evidence suggests that there is no systematic advantage of theory-based models of inflation dynamics over their astructural counterparts. This study reconsiders the issue by developing a 'semi-structural' forecasting procedure comprised of two key ingredients. First, a prediction for the cyclical component of inflation is obtained employing the concept of 'fundamental inflation'. The latter is computed from a canonical two-country monetary model, either via estimation of the reduced-form parameters of the New Keynesian Phillips Curve by the generalized methods of moments, or via calibration of its structural parameters. The computation of fundamental inflation requires multistep forecasts for the model-implied cyclical inflation drivers, which we generate via respective auxiliary vector autoregressions. Second, a driftless random walk prediction is employed for the trend component of inflation, on which theory has little to say. Using quarterly data for both the United States and the Euro Area for the period 1970-2010, and rolling window re-estimation to accommodate gradual structural change, we find that such semi-structural inflation forecasts outperform conventional univariate forecasts at all examined horizons. Our results thus suggest that theory can indeed play an important role in forecasting inflation, when appropriately combined with relevant data-driven features.

Keywords: fundamental inflation; New Keynesian Phillips Curve; inflation dynamics; predictive accuracy; money in the open economy; semi-structural forecasting (search for similar items in EconPapers)
JEL-codes: C52 C53 E31 E37 F41 F47 (search for similar items in EconPapers)
Pages: 63 pages
Date: 2014-05-29
New Economics Papers: this item is included in nep-cba, nep-eec, nep-for, nep-mac and nep-mon
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http://www.reading.ac.uk/web/FILES/economics/emdp2014108.pdf

Related works:
Journal Article: Inflation forecasting using the New Keynesian Phillips Curve with a time-varying trend (2020)
Working Paper: NKPC-Based Inflation Forecasts with a Time-Varying Trend (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:rdg:emxxdp:em-dp2014-03

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