Predicting inflation expectations: A habit-based explanation under hedging

Abstract

One of the main challenges monetary policymakers face is predicting the trajectory of short-term inflation, especially considering the consistently flat Phillips curve observed in recent years. A promising approach to tackling this challenge involves modifying the hybrid New Keynesian Phillips curve (HNKPC) by incorporating a hedging factor. This factor accounts for the efforts risk-averse economic agents make to safeguard their spending decisions against uncertainties arising from inflation. Our study provides evidence that the hedging factor plays a crucial role and is a statistically significant predictor of the upcoming year's inflation rate. Specifically, a one-standard-deviation increase in the hedging factor predicts a positive rise in short-term inflation. Furthermore, we demonstrate that the hedging factor significantly determines the common component found in both well-known survey-based and model-based inflation expectation indicators.