RDP 9207: Indicators of Inflationary Pressure 6. Concluding Remarks

In this paper we have examined the forecasting performance of several indicators of inflation. Because of inertia in the inflation rate, lags of inflation are good indicators of future inflation. The velocity (of currency) gap and currency growth do well in forecasting inflation in the period March 1984 to June 1990, but not since. This is due to the large, exogenous, fall in the velocity that has occurred since that time. Real variables, such as the rate of capacity utilisation, appear to have been the best indicators of recent inflation. The P* model, in various forms, does not appear to forecast well at any time.

This evidence is difficult to interpret because two independent events occurred late in 1990 – both the inflation rate and the velocity of currency started to fall rapidly. Nevertheless, we draw the following conclusions: when the velocity of currency and the inflation rate are relatively stable, the velocity gap and currency growth serve quite well as signals of incipient changes to the inflation rate. However, when the rate of inflation is changing rapidly, due to large fluctuations in the pace of economic activity, real variables such as the rate of capacity utilisation, deviations of output from its trend, and the rate of cyclical unemployment are the best indicators of inflationary pressure.