A New Model of Inflation, Trend Inflation, and Long-Run Inflation Expectations

Abstract

A knowledge of the level of trend inflation is key to many current policy decisions, and several methods of estimating trend inflation exist. This paper adds to the growing literature which uses survey-based long-run forecasts of inflation to estimate trend inflation. We develop a bivariate model of inflation and long-run forecasts of inflation which allows for the estimation of the link between trend inflation and the long-run forecast. Thus, our model allows for the possibilities that long-run forecasts taken from surveys can be equated with trend inflation, that the two are completely unrelated, or anything in between. By including stochastic volatility and time-variation in coefficients, it extends existing methods in empirically important ways. We use our model with a variety of inflation measures and survey-based forecasts. We find that long-run forecasts can provide substantial help in refining estimates of trend inflation over popular alternatives. But simply equating trend inflation with the long-run forecasts is not appropriate.

Keywords: trend inflation, inflation expectations, state space model, stochastic volatility

JEL Classification: C11, C32, E31