Inflation dynamics and persistence: The importance of the uncertainty channel

Abstract

In this article, we employ a time-varying GARCH-type specification to model inflation and investigate the behaviour of its persistence. Specifically, by modelling the inflation series as AR(1)-APARCH(1,1)-in-mean-level process with breaks, we show that persistence is transmitted from the conditional variance to the conditional mean. Accordingly, we propose a new measure of time-varying persistence, which not only distinguishes between changes in the dynamics of inflation and its volatility but also allows for feedback between the two variables. Analysing the inflation series for a number of countries, we find evidence that inflation uncertainty plays an important role in shaping expectations, and a higher level of uncertainty increases inflation persistence. We also consider a number of unit root tests and present the results of a Monte Carlo experiment to investigate the size and power properties of these tests in the presence of breaks in the mean and the variance equation of an AR(1)-APARCH(1,1)-in-mean-level data generating process. The Monte Carlo experiment reveals that if the model is misspecified, then commonly used unit root tests will misclassify inflation as a nonstationary, rather than a stationary process.