Improving Inflation Forecasts in the Medium to Long Term

Abstract

To accurately forecast the future rate of inflation, it is imperative to account for inflation’s underlying trend. This is especially important for medium- to long-run forecasts. In this Commentary I demonstrate a simple but powerful technique for incorporating this trend into standard statistical time series models and report the gains to accuracy. I find that incorporating the trend by modeling inflation as gap from an estimated underlying trend leads to substantial gains in forecast accuracy of about 20 percent to 30 percent, two to three years out.