Observed Inflation Forecasts and the New Keynesian Phillips Curve

Estimating the micro-founded New Keynesian Phillips Curve using rational inflation expectation proxies has often found that the output gap is not a valid measure of inflation pressure. This paper investigates the empirical success of the NKPC in explaining US inflation, using observed measures of inflation expectations and taking account of serial correlation in the stylized NKPC. Contrary to recent results indicating no role for the GDP gap, we find it to be a statistically significant driving variable for inflation while labor income share is generally insignificant. The paper also develops an extended model in which serial correlation is absent and the output gap remains a valid inflation driving force. In most of our estimations, however, lagged inflation dominates the role of inflation expectations, casting doubt on the extent to which price setting is forward-looking over the period 1968 to 2005. From an econometric perspective, the paper uses GMM estimation to account for endogeneity while also addressing concerns raised in recent studies about weak instrumental variables used in estimating NKPC models.