RDP 2015-04: The Sticky Information Phillips Curve: Evidence for Australia 5. Conclusion

The Sticky Information Phillips Curve provides a theoretically appealing alternative to the New-Keynesian Phillips curve. The key assumption that macroeconomic news disseminates slowly throughout the population is intuitively appealing, and enables the model to match empirical estimates of the dynamic response of inflation to monetary policy shocks, unlike the NKPC. This paper provides the first estimates of the SIPC for Australia. Overall, the results do not lend strong support to the model. The estimated parameters are sensitive to sample periods and inflation measures, and are theoretically inconsistent for several specifications.

The disappointing empirical performance of the SIPC can be in part explained by a change in the behaviour of inflation since the introduction of inflation targeting: the inertial trend component of inflation – that the SIPC provides a microfoundation for – accounts for a smaller share of the overall variability in inflation than in the past. Accordingly, including data prior to the inflationtargeting period in the estimation sample improves the performance of the SIPC. However, the NKPC appears to fit the data at least as well as the SIPC. The performance of the SIPC is particularly affected by the weak connection between the real and nominal side of the model. Furthermore, the NKPC is better able to explain the disinflation because it places less weight on long-horizon inflation forecasts, which (based on model estimates) substantially overpredicted inflation in the early 1990s. Taking account of differences in forecast measures used and restrictions placed on the model parameters, these findings are broadly in line with evidence for the United States and Europe.

While the results provide little support for the SIPC, particularly over the lowinflation period, they should not necessarily be taken as evidence against the importance of information rigidities. Since the introduction of inflation targeting, it has become more difficult to model inflation. The share of variation in inflation explained by a wide range of models has fallen together with the overall variation in inflation. Few models can now outperform a forecast of constant inflation of 2.5 per cent (midpoint of the RBA's target band). The poor performance of the SIPC over the low-inflation period in part reflects this more general finding, and not necessarily a rejection of the importance of information rigidities. Alternate tests find evidence consistent with information rigidities. For example, Coibion and Gorodnichenko (2012) show that the response of survey forecast errors to economic shocks supports the sticky-information model. The behaviour of consumer inflation expectations is also consistent with slow diffusion of economic news throughout the population (Carroll 2003). The core assumption of the SIPC that macroeconomic news disseminates slowly throughout the population is attractive, and the SIPC provides a useful framework for thinking through the effects on inflation. One possible means of improving the performance of the SIPC might be to introduce state-dependence in the frequency with which firms update their expectations. This would allow inflation to respond quickly to some shocks, but retain the predicted inertial response to monetary policy shocks.