Time–frequency relationship between US inflation and inflation uncertainty: evidence from historical data
| DOI | http://doi.org/10.1111/sjpe.12207 |
| Author | Aviral Kumar Tiwari,Claudiu Tiberiu Albulescu,Rangan Gupta,Stephen M. Miller |
| Date | 01 November 2019 |
| Published date | 01 November 2019 |
TIME–FREQUENCY RELATIONSHIP
BETWEEN US INFLATION AND
INFLATION UNCERTAINTY:
EVIDENCE FROM HISTORICAL DATA
Claudiu Tiberiu Albulescu*, Aviral Kumar Tiwari**, Stephen M. Miller***
and Rangan Gupta****
ABSTRACT
We provide new evidence on the relationship between inflation and its uncer-
tainty in the United States on an historical basis, covering the period from 1775
to 2014. First, we use a bounded approach for measuring inflation uncertainty,
as proposed by Chan et al. (2013), and compare the results with the Stock and
Watson (2007) and Chan (2015) methods. Second, we employ the wavelet
methodology to analyze the comovements and causal effects between the two ser-
ies. Our results provide evidence of a relationship between inflation and its uncer-
tainty that varies across time and frequency. First, we show that in the medium
and long runs, the Freidman–Ball hypothesis holds with a bounded measure of
uncertainty, while if the Stock and Watson (2007) measure of uncertainty is
used, the Cukierman–Meltzer reasoning prevails. Therefore, the findings are sen-
sitive to the way inflation uncertainty is computed. Second, we discover mixed
evidence about the inflation–uncertainty nexus in the short run, findings that
explain the mixed results reported to date in the empirical literature.
II
NTRODUCTION
During the 1960s, macroeconomists embraced the Phillips curve as a menu of
outcomes that policy makers could select through the appropriate implemen-
tation of macroeconomic policy levers. That is, the Phillips curve at that time
showed a trade-off between unemployment and inflation. In the 1970s, actual
policy choices led to stagflation, which shattered the belief in the Phillips
curve menu idea and led to the important role of inflation expectations and
‘inflation uncertainty’. Friedman (1968) and Phelps (1967) independently pre-
dicted this outcome whereby the government’s lack of commitment toward
inflation influences price expectations, which shifts the short-run Phillips
*Politehnica University of Timisoara
**Montpellier Business School
***University of Nevada
****University of Pretoria
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12207, Vol. 66, No. 5, November 2019
©2019 Scottish Economic Society.
673
curve. Consequently, the variability in inflation over time depends on the lim-
its established for an acceptable inflation rate.
The link between the level of inflation and its uncertainty became one of
the focal points of the economic literature, with the Nobel lecture of Fried-
man (1977) making two arguments about the inflation–unemployment trade-
off. First, Friedman argues that no stable trade-off exists between inflation
and unemployment. Second, he argues that higher inflation rates mean more
inflation volatility and uncertainty (first hypothesis), which, in turn, reduces
economic efficiency because of confused signals about the price changes (sec-
ond hypothesis). More precisely, increasing the inflation to achieve full
employment creates a strong incentive to counter it, and generates increased
uncertainty about future inflation, as policies go from one direction to the
other. Furthermore, a higher uncertainty about inflation negatively affects
output due to breakdowns in the price mechanism. Consequently, ‘this uncer-
tainty –or more precisely, the circumstances producing this uncertainty –
leads to systematic departures from the conditions required for a vertical Phil-
lips curve’ (Friedman, 1977, pp. 465).
Ball (1992) formalized the positive relationship between inflation and infla-
tion uncertainty that Friedman (1977) highlighted, now known as the Fried-
man–Ball hypothesis. Ball (1992) argues that high inflation creates uncertainty
about future monetary policy. In his asymmetric information model, he con-
siders two types of policy makers, which fight against inflation (weak and
strong types), and the public that does not know the policy-maker type.
Therefore, uncertainty exists regarding the actions the policy makers will take
when faced with high inflation, which leads to increased inflation uncertainty.
Starting from Friedman’s (1977) theory, Cukierman and Meltzer (1986) for-
mulate an alternative hypothesis, showing that high inflation uncertainty leads
to high inflation. They argue that in the presence of high inflation uncertainty,
the monetary authority may create inflation surprises to stimulate real activity.
Hence, even if the monetary authority has no incentive to create inflation, it
attempts to stimulate the economy increase uncertainty about money and
inflation, raising the level of inflation. Consequently, inflation uncertainty pos-
itively influences inflation.
Other competing theories propose a negative relationship between inflation
and inflation uncertainty, contradicting the Friedman–Ball hypothesis. First,
Frohman et al. (1981) note that, if economic agents form their expectations
on predictable variables other than past inflation, then high inflation variabil-
ity accompanies low uncertainty. Second, Pourgerami and Maskus (1987) sug-
gest that a rising inflation reduces inflation uncertainty because economic
agents devote more resources to generate accurate predictions during inflation-
ary periods. Ungar and Zilberfarb (1993) formalize these assumptions theoret-
ically and show that high inflation does not necessarily cause high inflation
uncertainty.
Finally, starting from the Friedman–Ball and Cukierman–Meltzer hypothe-
ses, Holland (1995) demonstrates that data timing influences the link between
inflation and its uncertainty. Relying on US statistics, he shows that high
674 C.T.ALBULESCU,A.K.TIWARI,S.M.MILLERANDR.GUPTA
Scottish Journal of Political Economy
©2019 Scottish Economic Society
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