Inflation: Do Expectations Trump the Gap?∗

We measure the relative contribution of the deviation of real activity from its equilibrium (the gap), “supply-shock” variables, and long-horizon inflation forecasts for explaining the U.S. inflation rate in the post-war period. For alternative specifications for the inflation-driving process and measures of inflation and the gap, we reach a similar conclusion: the contri-bution of changes in long-horizon inflation forecasts dominates that for the gap and supply-shock variables. Put another way, variation in long-horizon inflation forecasts explains the bulk of the movement in realized inflation. Further, we find evi-dence that long-horizon forecasts have become substantially less volatile over the sample period, suggesting that perma-nent shocks to the inflation rate have moderated. Finally, we use our preferred specification for the inflation-driving process to compute a history of model-based forecasts of the inflation rate. For both short and long horizons, these forecasts are close to inflation expectations obtained from surveys. JEL Codes: C32, E31. 1