Phillips Curve forecasting in a small open economy
Stock and Watson (1999) show that the Phillips curve is a good forecasting tool in the United States. We assess whether this good performance extends to two small open economies, with relatively large tradable sectors. Using data for Australia and New Zealand, we find that the open economy Phillips curve performs poorly relative to a univariate autoregressive benchmark. However, its performance improves markedly when sectoral Phillips curves are used which model the tradable and non-tradable sectors separately. Combining forecasts from these sectoral models is much better than obtaining forecasts from a Phillips curve estimated on aggregate data. We also find that a diffusion index that combines a large number of indicators of real economic activity provides better forecasts of non-tradable inflation than more conventional measures of real demand, thus supporting Stock and Watson’s (1999) findings for the United States.