Board of Governors of the Federal Reserve System

November 2012 (Revised June 2013)

A State-Dependent Model for Inflation Forecasting

Andrea Stella and James H. Stock

Abstract:

We develop a parsimonious bivariate model of inflation and unemployment that allows for persistent variation in trend inflation and in the non-accelerating inflation rate of unemployment. The model, which consists of five unobserved components including the trends) with stochastic volatility, implies a time-varying vector autoregression model for changes in the rates of inflation and unemployment. The implied backwards-looking Phillips curve has a time-varying slope that is steeper in the 1970s than in the 1990s. Pseudo out-of-sample forecasting experiments indicate improvements upon univariate benchmarks. Since 2008, the implied Phillips curve has become steeper and the the non-accelerating inflation rate of unemployment has increased.

Keywords: Inflation forecasting, Phillips curve, trend-cycle model, NAIRU

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