The roles of inflation expectations, core inflation, and slack in real-time inflation forecasting

Using state-space modeling, we extract information from surveys of long-term inflation expectations and multiple quarterly inflation series to undertake a real-time decomposition of quarterly headline PCE and GDP-deflator inflation rates into a common long-term trend, common cyclical component, and high-frequency noise components. We then explore alternative approaches to real-time forecasting of headline PCE inflation. We find that performance is enhanced if forecasting equations are estimated using inflation data that have been stripped of high-frequency noise. Performance can be further improved by including an unemployment-based measure of slack in the equations. The improvement is statistically significant relative to benchmark autoregressive models and also relative to professional forecasters at all but the shortest horizons. In contrast, introducing slack into models estimated using headline PCE inflation data or conventional core inflation data causes forecast performance to deteriorate. Finally, we demonstrate that forecasting models estimated using the Kishor-Koenig (2012) methodology-which mandates that each forecasting VAR be augmented with a flexible state-space model of data revisions-consistently outperform the corresponding conventionally estimated forecasting models