Title

Modeling Inflation After the Crisis

Author(s)

James H. Stock James Stock (Harvard University)

Mark W. Watson Mark Watson (Princeton University)

Abstract

In the United States, the rate of price inflation falls in recessions. Turning this observation into a useful inflation forecasting equation is difficult because of multiple sources of time variation in the inflation process, including changes in Fed policy and credibility. We propose a tightly parameterized model in which the deviation of inflation from a stochastic trend (which we interpret as long-term expected inflation) reacts stably to a new gap measure, which we call the unemployment recession gap. The short-term response of inflation to an increase in this gap is stable, but the long-term response depends on the resilience, or anchoring, of trend inflation. Dynamic simulations (given the path of unemployment) match the paths of inflation during post-1960 downturns, including the current one.

Creation Date

2010-10

Section URL ID

Paper Number

2010-1

URL

http://www.princeton.edu/~mwatson/papers/stock-watson_frbkc_2010.pdf

File Function

Jel

C22, E31

Keyword(s)

Inflation

Suppress

false

Series

13