Inflation forecasting using the New Keynesian Phillips Curve with a time-varying trend

Abstract

Does theory aid in ‡ation forecasting? To address this question, we develop a novel forecasting procedure based upon a New Keynesian Phillips Curve that incorporates time-varying trend in ‡ation, to capture shifts in central bank preferences and monetary policy frameworks. We generate theory-implied predictions for both the trend and cyclical components of in ‡ation, and recombine them to obtain an overall in ‡ation forecast. Using quarterly data for the Euro Area and the United States that cover almost half a century, we compare our in ‡ation forecasting procedure against the most popular time series models. We …nd that our theorybased forecasts outperform these benchmarks that previous studies found di¢ cult to beat. Our results are shown to be robust to structural breaks, geographic areas, and variants of the econometric speci…cation. Our …ndings suggest that the skepticism concerning the use of theory in forecasting is unwarranted, and theory should continue to play an important role in policymaking.

Forecasting inflation in Latin American countries using a SARIMA–LSTM combination

“…The second approach is based on macroeconomic models with microeconomic foundations. The stream of research that this second line of work is based on focuses on the New Keynesian Phillips Curve (NKPC) (e.g., Galá and Gertler, 1999;Atkeson et al, 2001;Adolfson et al, 2007;Cogley and Sbordone, 2008;Cai et al, 2019;and McKnight et al, 2020). In particular, the NKPC is an aggregate inflation equation arising in dynamic stochastic general equilibrium (McKnight et al, 2020).…”

“…The stream of research that this second line of work is based on focuses on the New Keynesian Phillips Curve (NKPC) (e.g., Galá and Gertler, 1999;Atkeson et al, 2001;Adolfson et al, 2007;Cogley and Sbordone, 2008;Cai et al, 2019;and McKnight et al, 2020). In particular, the NKPC is an aggregate inflation equation arising in dynamic stochastic general equilibrium (McKnight et al, 2020). McKnight et al (2020) do note that while the NKPC approach is based on macroeconomic models with microeconomic foundation, the theoretical underpinnings that drive inflation, they have not performed as well as time-series approaches.…”

“…In particular, the NKPC is an aggregate inflation equation arising in dynamic stochastic general equilibrium (McKnight et al, 2020). McKnight et al (2020) do note that while the NKPC approach is based on macroeconomic models with microeconomic foundation, the theoretical underpinnings that drive inflation, they have not performed as well as time-series approaches. In order to improve the NKPC models, McKnight et al (2020) introduced variation in the trend inflation and a novel procedure using 'time-varying' NKPC (TVT-NKPC).…”

“…McKnight et al (2020) do note that while the NKPC approach is based on macroeconomic models with microeconomic foundation, the theoretical underpinnings that drive inflation, they have not performed as well as time-series approaches. In order to improve the NKPC models, McKnight et al (2020) introduced variation in the trend inflation and a novel procedure using 'time-varying' NKPC (TVT-NKPC). The first approach to forecasting that McKnight et al (2020) mentioned uses various time-series analysis techniques.…”

“…There are essentially two approaches that are used to forecast inflation rate as noted by McKnight et al (2020). The first approach is driven by theory such as the New Keynesian Phillips Curve (NKPC); the second, uses time series techniques such as autoregressive moving averages.…”