Alternative Indicators to Predict the Probability of Declining Inflation

Abstract:     
This paper investigates the performance of inflation indicators for predicting the probability of inflation falling inside or outside constant and moving target ranges with a probit model for U.S. data. Particular attention will be given to the moving target range that future inflation will be below most recently observed inflation. This issue is motivated by the emphasis placed by the Federal Reserve System on the long-run objective of price stability, that can be achieved by the gradual reduction in the rate of inflation by monetary control. When the inflation target range is zero to the average of inflation over the preceding eight quarters, the capacity utilization rate and the unemployment rate forecast whether inflation will be inside or outside the target range much more accurately than the other indicators over the 1976:I-1997:IV period. In contrast, out-of-sample forecasting results for the 1990:I-1997:IV period for a moving target range yield commodity prices as best indicators.

Number of Pages in PDF File: 35

Keywords: Probit model, out-of-sample forecast, inflation targets, inflation indicators

JEL Classification: C25, E31, E37, G18

working papers series