Modelling U.K. Inflation Uncertainty : The Impact of News and the Relationship with Inflation

Uncertainty about future inflation is often claimed to be one of the most important costs of inflation, since it distorts the workings of the price system and leads to allocational inefficiencies. This paper analyses U.K. inflation between 1950 and 1994 using the ARCH methodology, which enables inflation uncertainty to be modelled directly. It examines two questions: first, what is the precise form of the relationship between shocks to the level of inflation and future inflation uncertainty? Second, what is the relationship between inflation uncertainty and the level of inflation? The paper finds that future inflation uncertainty is much more sensitive to "bad" news (unexpected increases in inflation) than "good" news. In fact, uncertainty appears almost unaffected when inflation outturns are lower than expected. It also finds that inflation uncertainty is indeed higher when inflation is high though the precise form of this relationship is difficult to estimate