Predicting Inflation Expectations : A Habit-Based Explanation Under Hedging

A key challenge for monetary policymakers is predicting the path of short-term inflation given the persistently flat Phillips curve of the last few years. A promising innovation involves modifying the hybrid-New Keynesian Phillips curve (NKPC) to include an interaction variable, reflecting the transaction activities of risk averse economic agents to inflation uncertainty. Our study documents that the hedging factor is an economic and statistically significant predictor of the coming year’s inflation rate, as a one standard deviation increase in the hedging factor forecasts a positive increase in the short-term inflation. We also show that the hedging factor significantly determines the common component in both the well-known survey based and model-based measures of inflation expectations