Monetary-Policy Rule as a Bridge: Predicting Inflation without Predictive Regressions

Jian Hua and Liuren Wu

Journal of Financial and Quantitative Analysis, 2018, vol. 53, issue 6, 2559-2586

Abstract: A major issue with predicting inflation rates using predictive regressions is that estimation errors can overwhelm the information content. This article proposes a new approach that uses a monetary-policy rule as a bridge between inflation rates and short-term interest rates and relies on the forward-interest-rate curve to predict future interest-rate movements. The 2-step procedure estimates the predictive relation not through a predictive regression but far more accurately through the contemporaneous monetary-policy linkage. Historical analysis shows that the approach outperforms random walk out of sample by 30%–50% over horizons from 1 to 5 years.

Date: 2018
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