Is the backward-looking component important in a New Keynesian Phillips curve?

Abstract

New Keynesian Phillips curves (NKPC) have recently been modified to include additional lags of inflation in the specification in order to capture the considerable persistence in postwar U.S. inflation. Furthermore, many researchers have agreed on the existence of structural changes in the persistence of inflation. Continuing with these literatures, we investigate the nature of structural changes in the hybrid NKPC and reconsider the role of the backward-looking component in the NKPC, taking into account the possibility of structural changes in the steady-state inflation rate. Our empirical results show multiple structural breaks in the NKPC in 1974 and 1982. Accounting for these structural changes, the backward-looking component is no longer significant throughout the whole sample period. In other words, the significant role of the backward-looking component in the earlier literature might be spuriously capturing the structural changes in the steady-state inflation rate. Thus, U.S. inflation dynamics are well explained by a pure NKPC if we take into account the possibility of structural changes in the steady-state inflation rate.