Inflation Persistence and the Rationality of Inflation Expectations

Book excerpt: The rational expectations hypothesis for survey and model-based inflation forecasts - from the Survey of Professional Forecasters and the Greenbook respectively - is examined by properly taking into account persistence in the data. The finding of nearunit-root effects in inflation and inflation expectations motivates the use of a local-tounity specification of the inflation process that enables us to test whether the data are generated by locally non-stationary or stationary processes. Thus, we test, rather than assume, stationarity of near-unit-root processes. In addition, we set out an empirical framework for assessing relationships between locally non-stationary series. In this context, we test the rational expectations hypothesis by allowing the co-existence of a long-run relationship obtained under the rational expectations restrictions with short-run "learning" effects. Our empirical results indicate that the rational expectations hypothesis holds in the long run, while forecasters adjust their expectations slowly in the short run. This finding lends support to the hypothesis that the persistence of inflation comes from the dynamics of expectations.