Modelling Inflation Volatility

32 Pages Posted: 6 Nov 2014 Last revised: 7 Nov 2014

See all articles by Eric Eisenstat

Eric Eisenstat

University of Bucharest

Rodney W. Strachan

University of Queensland - School of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: November 2014

Abstract

This paper discusses estimation of US inflation volatility using time varying parameter models, in particular whether it should be modelled as a stationary or random walk stochastic process. Specifying inflation volatility as an unbounded process, as implied by the random walk, conflicts with priors beliefs, yet a stationary process cannot capture the low frequency behaviour commonly observed in estimates of volatility. We therefore propose an alternative model with a change-point process in the volatility that allows for switches between stationary models to capture changes in the level and dynamics over the past forty years. To accommodate the stationarity restriction, we develop a new representation that is equivalent to our model but is computationally more efficient. All models produce effectively identical estimates of volatility, but the change-point model provides more information on the level and persistence of volatility and the probabilities of changes. For example, we find a few well defined switches in the volatility process and, interestingly, these switches line up well with economic slowdowns or changes of the Federal Reserve Chair. Moreover, a decomposition of inflation shocks into permanent and transitory components shows that a spike in volatility in the late 2000s was entirely on the transitory side and a characterized by a rise above its long run mean level during a period of higher persistence.

Keywords: Inflation volatility, monetary policy, time varying parameter model, Bayesian estimation, change-point model.

JEL Classification: C11, C22, E31

Suggested Citation

Eisenstat, Eric and Strachan, Rodney W., Modelling Inflation Volatility (November 2014). CAMA Working Paper No. 68/2014, Available at SSRN: https://ssrn.com/abstract=2519296 or http://dx.doi.org/10.2139/ssrn.2519296

Eric Eisenstat

University of Bucharest ( email )

14 Academiei St.
Bucharest, Bucuresti 70109
Romania

Rodney W. Strachan (Contact Author)

University of Queensland - School of Economics ( email )

Brisbane, QLD 4072
Australia

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