Forecasting inflation with an uncertain output gap

The output gap is a crucial concept in the monetary policy framework, indicating demand pressure that generates inflation. However, its definition and estimation raise a number of theoretical and empirical questions. This paper evaluates a series of univariate and multivariate methods for extracting the output gap in Norway, and compares their value added in predicting inflation. We find that models including the output gap have better predictive power than models based on alternative indicators, and they forecast significantly better than simple benchmark models. Furthermore multivariate measures of the output gap perform better than the univariate gaps. Comments from two anonymous referees, Q. Farooq Akram, Tommy Sveen, Ken West, Fredrik Wulfsberg and seminar participants in Norges Bank are gratefully acknowledged. All mistakes remain our own. The views expressed are those of the authors and do not necessarily represent those of Norges Bank.