Using a Wage-Price-Setting Model to Forecast U.S. Inflation

Abstract

Based on the key assumption that firms use a rule of thumb to set prices after settling a wage agreement, this study modifies a wage–price-setting (WPS) model to forecast U.S. inflation over one- to three-year horizons. The out-of-sample forecast results show that productivity growth is a useful predictor of inflation, in the sense that the modified WPS model improves upon some univariate benchmark models during the 1990Q1–2020Q2 period. Since the early 2000s, forecast accuracy can be improved further by combining productivity growth with anchored inflation expectations. Interestingly, during the 2000–2014 period, forecasts derived from the WPS model with constant inflation expectations have been found to slightly outperform Greenbook forecasts in forecasting quarter-over-quarter inflation with horizons up to four-quarter.