A new model of trend inflation

Chan, Joshua and Koop, Gary and Potter, Simon (2012): A new model of trend inflation.

Abstract

This paper introduces a new model of trend (or underlying) inflation. In contrast to many earlier approaches, which allow for trend inflation to evolve according to a random walk, ours is a bounded model which ensures that trend inflation is constrained to lie in an interval. The bounds of this interval can either be fixed or estimated from the data. Our model also allows for a time-varying degree of persistence in the transitory component of inflation. The bounds placed on trend inflation mean that standard econometric methods for estimating linear Gaussian state space models cannot be used and we develop a posterior simulation algorithm for estimating the bounded trend inflation model. In an empirical exercise with CPI inflation we find the model to work well, yielding more sensible measures of trend inflation and forecasting better than popular alternatives such as the unobserved components stochastic volatility model.

• Item Type: MPRA Paper
• Language: English
• Keywords: Constrained inflation; non-linear state space model; underlying inflation; inflation targeting; inflation forecasting; Bayesian
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C51 - Model Construction and Estimation; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E37 - Forecasting and Simulation: Models and Applications; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C11 - Bayesian Analysis: General

References

Chan, J. and Jeliazkov, I. (2009). "Efficient simulation and integrated likelihood estimation in state space models," International Journal of Mathematical Modelling and Numerical Optimisation, 1, 101-120.

Chan, J. and Strachan, R. (2012). "Estimation in non-linear non-Gaussian state-space models with precision-based methods," Technical report, Research School of Economics, Australian National University, Canberra.

Clark, T. and Davig, T. (2008). "An empirical assessment of the relationships among inflation and short- and long-Term expectations," Federal Reserve Bank of Kansas City Research Working Paper 08-05.

Clark, T. and Doh, T. (2011). "A Bayesian evaluation of alternative models of trend inflation," manuscript.

Cogley, T., Primiceri, G. and Sargent, T. (2010). "Inflation-gap persistence in the U.S.," American Economic Journal: Macroeconomics, 2, 43-69.

Cogley, T. and Sargent, T. (2005). "Drifts and volatilities: Monetary policies and outcomes in the post WWII U.S.," Review of Economic Dynamics, 8, 262-302.

Cogley, T. and Sbordone, A. (2008). "Trend inflation, indexation, and inflation persistence in the new Keynesian Phillips curve," American Economic Review, 98, 2101-2126.

Geweke, J. (2010). Complete and Incomplete Econometric Models. Princeton University Press, Princeton.

Ireland, P. (2007). "Changes in the Federal Reserve's inflation target: Causes and consequences," Journal of Money, Credit and Banking, 39, 1851-1882.

Koop, G. and Potter, S. (2007). "Estimation and forecasting in models with multiple breaks," Review of Economic Studies, 74, 763-789.

Koop, G. and Potter, S. (2011). "Time varying VARs with inequality restrictions," Journal of Economic Dynamics and Control, 35, 1126-1138.

Smets, F. and Wouters, R. (2003). "An estimated dynamic stochastic general equilibrium model of the Euro area," Journal of the European Economic Association, 1, 1123-1175.

Stock, J. and Watson, M. (2007). "Why has U.S. inflation become harder to forecast?," Journal of Money, Credit and Banking, 39, 3-33.

Stock, J. and Watson, M. (2010). "Modeling inflation after the crisis," manuscript prepared for the Federal Reserve Bank of Kansas City Symposium, "Macroeconomic Policy: Post-Crisis and Risks Ahead," Jackson Hole, Wyoming, August 26-28.

Williams, John C. (2009), "The risk of deflation," FRBSF Economic Letter, March 27.