Modeling Inflation After the Crisis

In the United States, the rate of price inflation falls in recessions.Turning this observation into a useful inflation forecasting equation is difficult because of multiple sources of time variation in the inflation process, including changes in Fed policy and credibility.We propose a tightly parameterized model in which the deviation of inflation from a stochastic trend (which we interpret as long-term expected inflation) reacts stably to a new gap measure, which we call the unemployment recession gap.The short-term response of inflation to an increase in this gap is stable, but the long-term response depends on the resilience, or anchoring, of trend inflation.Dynamic simulations (given the path of unemployment) match the paths of inflation during post-1960 downturns, including the current one.