Inflation and inflation forecasting: an introduction

Abstract

Although current inflation rates are relatively benign, the costs of unexpected inflation, even at low rates, remain substantial for individual firms and consumers. Many types of planning decisions, such as businesses' and governments' plans for expected expenses and revenues, hinge on inflation forecasts. ; This article provides an overview of the effects of inflation and the significance of inflation forecasting. The author first considers how forecasting models are specifically designed to fill the needs of particular users. The analysis examines two statistical models--the Phillips curve and money demand/monetarist models--that employ standard economic theory to suggest variables that help predict inflation. Forecasts from a simple, but widely used, version of each model are then compared with simple time series models that include only past data on inflation. This comparison using standard accuracy criteria shows that the economic models did not perform much better than the simplest time series forecasting model. The author concludes that future research should focus on estimating dynamic models that are by design more structural and that may help uncover the sources of inflation.