Measuring Unobserved Expected Inflation

• Date: 01 April 2016
• DOI: http://doi.org/10.1111/infi.12080
• Author: Rafi Melnick
• Published date: 01 April 2016

Measuring Unobserved Expected

Inflation

RafiMelnick

The Interdisciplinary Center Herzliya, Herzliya, Israel.

Abstract

The aim of this study is to develop an eclectic but robust model that

allows for a better measure of expected inflation and facilitates testing

for all sorts of biases. Improving the measure of expected inflation is of

critical importance for conducting monetar y policy. In many circum-

stances, indicators of expected inflation move in opposite directions,

and this divergence may be critical for the setting of the interest rate. I

estimate the model for a special set of Israeli data via the Kalman filter

methodology and then test for systematic biases, a better normalization

of the model, liquidity problems and inflation risk –which could all be

present in current measures of expected inflation.

I. Introduction

Assessing the r ate of expected inflatio n is of critic al importance for the task of

designing and carryi ng out monetary policy. Uncertain economic futures makes

choosing the appropriate forward-looking monetary p olicy a constant chal lenge for

This paper was motivated by t he responsibilities I had a s a member of the Monetary Comm ittee of

the Bank of Israel. I would like to thank Jacob Boudou kh, Alex Cukierman, Stanley Fischer, Alex Ilek,

Roy Stein and Mark Watson for helpful discussions; two anonymous referees for t heir comments and

suggestions; and Roy Stein an d Aviel Shpitalnik for help with the data.

International Finance 19:1, 2016: pp. 2–22

DOI: 10.1111/infi.12080

© 2016 John Wiley & Sons Ltd

monetary authorit ies. The purpose of th is paper is to offer an econometri c approach

to obtain an operat ional measure of expec ted inflation.

The implementati on of a proper forward-looking inflation targeting regime,

1

with

or without a Taylor-type interest -rate rule, requ ires a quantitat ive measure of

expected inflation. This is of crit ical importance be cause the adoption of an in flation

targeting strateg y for the conduct of monetary polic y

2

has become the preferred

strategy of an increasing number of countries.

3

Therefore, the approach develope d

here may have broad application s.

Expected inflation is not directly observed ; therefore, practically spe aking, the

execution of monetar y policy requi res an estimate of it. There are va rious estimates

of expected inflati on as indicators, includin g inflation forecasts, e xpert surveys and

expectations de rived from financial markets.

Monetary pol icy decisions base d on these indicators could b e problematic

because they may be subje ct to various sorts of errors, su ch as:

Biases in surveys and forecasts: Carg ill and Meyer (1985) examine the Living-

ston Survey and find a systematic 10% bias in its forecasts; Laster e t al. (1999)

discuss the p ossible rati onal bias in macro economic forecast s; Stock and

Watson (2007) explore why US inflation has become more difficu lt to forecast;

and Frenkel et al. (2013) discuss the strategic behaviour of professional

forecasters.

Risk and liquid ity problems for in dicators based on finan cial markets: Kandel

et al. (1996) estimate an inflation risk premium in n ominal interest rates; and

Pflueger and Viceira (2011) find a high liquidity premium, a large average real

interest rate risk premium and a sm aller inflation ri sk premium.

Model dependence and possibly misspecification.

Measurement errors and pure noise.

In many circumstances, the in dicators move in opposite directi ons. This diver-

gence may pose a chal lenge for the settin g of the interest rate.

4

In real world

situations, polic y makers need to identif y, by alternative methods, the correct level

and change of inflationary expec tations to avoid mone tary pol icy mistakes.

The approach in this pap er requires a numb er of indicators that encomp ass

expected inflation as a common fac tor. I draw on a cross-section of indicators of

1

Inflation targeting is the current framework for mon etary policy in Israel.

2

In a forward-looking inflati on targeting regime, the rate of i nterest is set according to the difference

between expected inflat ion and the inflation target.

3

Appendix 1 presents a list of 29 countries, f rom Roger (2009), that have adopted inflat ion targeting

along with their approximate dates of adoption.

4

In most cases, the central ban k sets a short-term interest rate.

Measuring Unobserved Expected Inflation 3

© 2016 John Wiley & Sons Ltd