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Monetary-Policy Rule as a Bridge: Predicting Inflation without Predictive Regressions

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  • Hua, Jian
  • Wu, Liuren

Abstract

A major issue with predicting inflation rates using predictive regressions is that estimation errors can overwhelm the information content. This article proposes a new approach that uses a monetary-policy rule as a bridge between inflation rates and short-term interest rates and relies on the forward-interest-rate curve to predict future interest-rate movements. The 2-step procedure estimates the predictive relation not through a predictive regression but far more accurately through the contemporaneous monetary-policy linkage. Historical analysis shows that the approach outperforms random walk out of sample by 30%–50% over horizons from 1 to 5 years.

Suggested Citation

  • Hua, Jian & Wu, Liuren, 2018. "Monetary-Policy Rule as a Bridge: Predicting Inflation without Predictive Regressions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(6), pages 2559-2586, December.
    • Handle: RePEc:cup:jfinqa:v:53:y:2018:i:06:p:2559-2586_00
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    Cited by:

    1. Li, Kai, 2019. "Portfolio selection with inflation-linked bonds and indexation lags," Journal of Economic Dynamics and Control, Elsevier, vol. 107(C), pages 1-1.
    2. Peter Carr & Liuren Wu, 2023. "Decomposing Long Bond Returns: A Decentralized Theory," Review of Finance, European Finance Association, vol. 27(3), pages 997-1026.

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