Inflation dynamics, the role of inflation at different horizons and inflation uncertainty

Abstract

Despite a widespread adoption of the hybrid new Keynesian Phillips curve (NKPC), previous empirical studies deliver conflicting results as to the relative importance of forward- and backward-looking behavior, depending on empirical specifications and econometric methods. This paper contributes to this important issue by showing that the role of expected inflation in the NKPC also hinges on inflation at different horizons (referred to as inflation horizons henceforth). The main result reveals that the quantitative importance of forward-looking behavior becomes smaller as the inflation horizon is long. It comes out of a positive correlation of the inflation horizon with inflation uncertainty. This positive link renders firms more likely to have recourse to a safe way (e.g., the use of information about past prices as a forecasting rule) to set their current prices to avoid greater price uncertainty created by the distant future. The changing role of forward-looking behavior at different inflation horizons implies that the NKPC may embrace both the view of the important role of expected inflation and the opposite view that backward-looking behavior matters, rendering different policy recommendations. Various robustness analyses do not reverse the main finding.