Inflation persistence, learning dynamics and the rationality of inflation expectations

The rational expectations hypothesis for survey and model-based inflation forecasts—from the Survey of Professional Forecasters and the Greenbook respectively—is examined by properly taking into account the persistence characteristics of the data. The finding of near-unit-root effects in the inflation and inflation expectations series motivates the use of a local-to-unity specification of the inflation process that enables us to test whether the data are generated by locally non-stationary or stationary processes. Thus, we test, rather than assume, stationarity of near-unit-root processes. The paper combines the concept of localities in the underlying time series, such as those that may exist in the sample but not in the population, with cointegration analysis which permits the distinction between short-run and long-run structures. Thus, we examine possible in-sample departures from rationality both in the short run and the long run. Our empirical results indicate that the rational expectations hypothesis holds in the long run, while forecasters adjust their expectations slowly in the short run. This finding lends support to the hypothesis that the persistence of inflation comes from the dynamics of expectations.