A New Model of Trend Inflation

31 Pages Posted: 24 Feb 2012

See all articles by Joshua C. C. Chan

Joshua C. C. Chan

University of Technology Sydney (UTS) - UTS Business School; Purdue University

Gary Koop

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics

Simon Potter

Federal Reserve Bank of New York

Date Written: February 2012

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.

Keywords: constrained inflation, non-linear state space model, underlying inflation, inflation targeting, inflation forecasting, Bayesian

Suggested Citation

Chan, Joshua C. C. and Koop, Gary and Potter, Simon, A New Model of Trend Inflation (February 2012). Available at SSRN: https://ssrn.com/abstract=2010261 or http://dx.doi.org/10.2139/ssrn.2010261

Joshua C. C. Chan (Contact Author)

University of Technology Sydney (UTS) - UTS Business School ( email )

Sydney
Australia

Purdue University

West Lafayette, IN 47907-1310
United States

Gary Koop

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics ( email )

100 Cathedral Street
Glasgow G4 0LN
United Kingdom

Simon Potter

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-6309 (Phone)
212-720-1844 (Fax)

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