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Monetary-Policy Rule as a Bridge: Predicting Inflation without Predictive Regressions

Published online by Cambridge University Press:  02 October 2018

Jian Hua  and
Liuren Wu
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Abstract

A major issue with predicting inflation rates using predictive regressions is that estimation errors can overwhelm the information content. This article proposes a new approach that uses a monetary-policy rule as a bridge between inflation rates and short-term interest rates and relies on the forward-interest-rate curve to predict future interest-rate movements. The 2-step procedure estimates the predictive relation not through a predictive regression but far more accurately through the contemporaneous monetary-policy linkage. Historical analysis shows that the approach outperforms random walk out of sample by 30%–50% over horizons from 1 to 5 years.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 53 , Issue 6 , December 2018 , pp. 2559 - 2586
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

The authors thank Tobias Adrian, David Backus, Mikhail Chernov, Todd Clark, Jennifer Conrad (the editor), Francis X. Diebold, Taeyoung Doh, Andrew Karolyi, Edith Liu, Eric Sims (the referee), Oleg Sokolinskiy, Byron Tsang, Jonathan Wright, and participants at Baruch College, Queens College, New York University, the 2013 Annual Society for Financial Econometrics (SoFiE) Conference, and the 2014 Triple Crown Conference for comments.

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