U.S INFLATION

U.S Inflation

Abstract

We use over two hundred years of US inflation data to examine the impact of inflation uncertainty on inflation. An analysis of the full period without allowing for various regimes shows no impact of uncertainty on inflation. However, once we distinguish between recessions and non recessions, we find that inflation uncertainty has a negative effect on inflation only in recession times, thus providing support to the Holland hypothesis.

Table of Contents

Introduction4

Discussion5

Real Estate8

Infrastructure8

Data and model9

Results10

Conclusions12

References14

Appendix16

U.S Inflation

Introduction

The relationship between inflation and inflation uncertainty has drawn significant attention in the empirical macroeconomic literature recently. Macroeconomic theory predicts a bidirectional causal relationship. Friedman (1977) argues that in inflationary times there is uncertainty among the public regarding the likely response of the monetary authority, thus leading to inflation uncertainty. Hence, inflation has a positive effect on inflation uncertainty. The sign of the impact of inflation uncertainty on inflation, though, is ambiguous from a theoretical point of view. It depends on the reaction of the central bank to an increase in inflation uncertainty. The central bank may react opportunistically creating an inflation surprise to reap output gains. Alternatively, the central bank may act in a stabilizing manner reducing inflation in order to offset the increase in inflation uncertainty and its output destabilizing effects (Holland, 1995).

The empirical literature on the inflation-inflation uncertainty nexus has multiplied tremendously over the last few years. The majority of this literature has examined the link between the two variables abstracting from the consideration of regime changes in inflation and/or inflation uncertainty (e.g., Grier and Perry, 1998, Bredin and Fountas, 2009). In general, there is no consensus arising from this vast literature, in particular on the Cukierman-Meltzer hypothesis. It is anticipated though that regime shifts are important and the impact of inflation uncertainty on inflation may be sensitive to such shifts. Evans (1991) considers the sensitivity of inflation uncertainty to regime shifts in inflation. Using a similar approach, Caporale and Kontonikas (2009) highlight the impact of the impact of the euro regime on inflation uncertainty in euro zone countries. In this paper, we focus on the impact of recessions on the effect of inflation uncertainty on inflation. Recessionary periods are expected to have an influence on inflation uncertainty and possibly on the reaction of the central bank, thus altering the sensitivity of inflation to changes in inflation uncertainty.

One innovation lies in the use of a very long US inflation data set that covers over two centuries and encompasses several periods of recession. This represents the most comprehensive sample examined to date for the issue in hand. Historical inflation data sets for other countries have been used to examine the inflation-inflation relationship but none of these studies have considered the impact of recession regimes. Fountas (2001) uses UK data, and Thornton (2008) uses data on Argentina. Using an asymmetric Generalized Autoregressive Conditional Heteroskedasticity in-mean (GARCH-M) model we find that inflation uncertainty increases during recessions and the central bank responds by decreasing ...