A Model of the Fed's View on Inflation

Abstract

A view often expressed by the Fed is that three components matter in inflation dynamics: a trend anchored by long run inflation expectations; a cycle connecting nominal and real variables; and oil prices. This paper proposes an econometric structural model of inflation formalising this view. Our findings point to a stable expectational trend, a sizeable and well identified Phillips curve and an oil cycle which, contrary to the standard rational expectation model, affects inflation via expectations without being reflected in the output gap. The latter often overpowers the Phillips curve. In fact, the joint dynamics of the Phillips curve cycle and the oil cycles explain the inflation puzzles of the last ten years.

Keywords: Expectations, inflation, oil prices, Phillips curve