Ination dynamics and expectation errors in the US: an Unobserved Component model with Markov-Switching regimes

This article proposes an empirical representation of the in‡ation expectations in an Unobserved Components model with Markov-Switching regimes. This State-Space representation aims to answer two questions. Are the expectation errors consistent with the weak form of the Rational Expectations Hypothesis? If this is not the case for certain periods, are the di¤erent schemes of expectation associated with di¤erent slopes for the Phillips curve? One novel feature of this article consists in allowing the parameters of the State-Space model to switch to di¤erent values according to the regimes. The other one relies on the joint estimation of two unobservable components by the Kalman …lter: the expected in‡ation rate and the natural rate of unemployment. Empirical results for the United States suggest that the dynamics of in‡ation expectation errors change across regimes. Moreover, these switches occur simultaneously with a change in the slope of the Phillips curve during the last thirty years. Keywords: State-Space representation; Markov-Switching model; In‡ation expectation errors; Phillips curve; Peso e¤ects JEL classi…cation: E3, C32, C51 1 Banque de France, Direction de la Recherche, 41-1422 POMONE, 75049 Paris cedex 01. Tél. 01 4292 4965, Fax. 01 4292 6292. E-mail: [email protected]. The opinions herein re‡ect those of the authors and do not necessarily express the views of the Banque de France.