P∗ revisited: money-based inflation forecasts with a changing equilibrium velocity

Abstract

Alternate recursive estimates of equilibrium velocity are obtained by applying regression trees and OLS methods to a standard representation of M2 demand. Equilibrium velocity is defined as the velocity level that would be expected to hold if deposit rates were at their long-run average (equilibrium) value. We simulate the alternative models to obtain real-time forecasts of inflation and evaluate the performance of the forecasts obtained from the alternative models. While a P ∗ model based on a constant equilibrium velocity does not provide accurate inflation forecasts over the 1990s, we find that a model based on our time-varying equilibrium velocity estimates is quite accurate.