Working Paper: NBER ID: w16488
Authors: James H. Stock; Mark W. Watson
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.
Keywords: Inflation; Unemployment; Recession; Forecasting
JEL Codes: C22; E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unemployment recession gap (J64) | inflation (E31) |
| unemployment recession gap (J64) | inflation (E31) |