Modeling inflation expectations in Pakistan

This study examines the macroeconomic determinants of inflation expectations in Pakistan. We used 5-month moving average technique to generate future inflation in Pakistan using the monthly data for the period of Sep-03 to July-11. The study undertook FMOLS and ECM approach to assess the short run and long run impact of independent variables through hybrid new Keynesian type Phillips curve. The results suggest that inflation expectation generated through the 5-month moving average well captured the turning points in actual inflation. While in the exploration process of the determinants of expected inflation, the empirical results indicate that money supply, gold price, real effective exchange rate, real interest rate, and food inflation are main determining variables while output gap and nominal interest rate have no significant impact on expected inflation in Pakistan. Interesting conclusion drawn is that in the long run CPI index of fuel and energy is significant but in the short run the international crude oil price is significant. The importance of past inflation in determining expectations appears to be relatively low in the short run, but in the long run. The overall empirical evidence does suggest the presence of substantial inertia in the inflation process in the long run.