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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time
Athanasios Orphanides and Simon van Norden

Abstract: A stable predictive relationship between inflation and the output gap, often referred to as a Phillips curve, provides the basis for countercyclical monetary policy in many models. In this paper, we evaluate the usefulness of alternative univariate and multivariate estimates of the output gap for predicting inflation. Many of the ex post output gap measures we examine appear to be quite useful for predicting inflation. However, forecasts using real-time estimates of the same measures do not perform nearly as well. The relative usefulness of real-time output gap estimates diminishes further when compared to simple bivariate forecasting models which use past inflation and output growth. Forecast performance also appears to be unstable over time, with models often performing differently over periods of high and low inflation. These results call into question the practical usefulness of the output gap concept for forecasting inflation.

Keywords: Phillips curve, output gap, inflation forecasts, real-time data

Full paper (238 KB PDF)

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Last update: December 21, 2004