Predictive Abilities of Inflation Expectations and Implications on Monetary Policy in Korea

Abstract

This paper examines the predictive abilities of various inflation expectation indicators for inflation in Korea. We conducted real-time out-of-sample forecasting experiments utilizing three inflation expectation indicators – the general public’s expectation, professional forecasters’ expectation, and break-even inflation (BEI). The results can be summarized as follows: (i) BEI is at least as useful as the other expectation indicators in forecasting inflation; (ii) regression-based models using industrial production, oil price, and exchange rate do not help out-of-sample inflation forecasting in general; (iii) the policy interest rate, in contrast, can significantly reduce the forecasting errors; and (iv) a one percent-point increase in the policy interest rate is estimated to suppress inflation for the subsequent 12 months by around one percent-point. These results suggest that monetary policy is effective for controlling inflation and a simple model using the policy interest rate and an inflation expectation indicator may be preferred for inflation forecasting.