Forecasting in an inflation-

targeting central bank

Lavan Mahadeva

Centre of Central Banking Studies

Bank of England

Presentation at the
Banco Central del Reserva del Perú
Lima, 2002
 Why do central banks forecast?
• All monetary policymakers have to
explicitly or implicitly make a forecast to
advise policy
• All discretionary monetary policymakers
(inflation and money targeters) use a
forecast to explain policy
 Inflation targets and inflation "targeters"
Number of countries 60
with inflation targets
50

40

30

20

10
inflation "targeters"
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Sources: inflation "targeters" is taken from Mishkin and Schmidt-Hebbel (2000). Total number of inflation
targets taken from Bank of England survey in FJMRS (2000), extended by authors for 1999 and 2000
including estimates
 Explicit inflation targets in and out of steady-state
60

50

40

away from 30
steady-state
20

10
in steady-state
8 7 10 6 6
2 2 3 4 5
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Sources: Bank of England survey in FJMRS (2000), extended by authors for 1999 and 2000 including
estimates. Steady-state targets are defined as those targets that are 3% or less, and do not change from the
previous period
 The monetary policy problem
Inflation rate
current
inflation rate

I. The initial
inflation rate is far
away from the long- Long-
run target run
target
rate
Time
Inflation rate
current
inflation rate

I. The initial
inflation rate is far
away from the long- Long-
run target run
II. It takes time to
target
return to target
without excessive rate
output costs
Time
 The monetary policy problem
Inflation rate

current III. During this time,

inflation rate there are many
uncertainties

I. The initial
inflation rate Long-run
is far away target
from the long-
run target II. It takes time to return to target
without excessive output costs
Time
 Inflation target misses by value of inflation target
Table *: Inflation target misses at different magnitudes of inflation targets
Average Target (T) “Strict” Low targets High targets 10
inflation 0<T<=2.5 3<=T<=17.5
targeters*
Observations 96 48 48 8
Median miss -.35 -.35 -.30
Median absolute miss 0.98 .55 1.45 6

percentage points
4

75th percentile miss 2

median miss

0
T <=2.5 2.5 <T<= 4.5 4.5<T<=8 8<T<=15 Above 15
-2
25th percentile miss

-4
Inflation target
 Inflation target revisions by value of inflation target

6
90th percentile
4
Revision (percentage points)

0 75th percentile
T <=2.5 2.5 <T<=4.5 4.5<T<=8 8<T<=12 Above 12
-2

-4
median
-6 25th percentile
-8

-10 10th percentile

-12
Inflation target (percentage points)
 Conclusions
• Spread of targets to disinflating countries
changes interpretation of targets
A target becomes a conditional forecast
• Clear policy rule (or target rule) on bumpy paths
to price stability may not exist
• Conditional targets may be a key part of the
framework for successful disinflations
• Greater need for transparency and coordination
What do structural breaks imply?
• Econometric technique/ past data is likely to
be of limited use
• off-model information is going to be of
much use ( MODEL ADJUSTMENT)
• We are going to keep getting it wrong
(EXPLAINING UNCERTAINTY)
 But CBs still must forecast.
Why?
CB needs to form a consistent picture of the
economy
• to explain their decisions to the public-
TRANSPARENT EXPLANATIONS
• to come to an internal agreement-
INTERNAL DISCIPLINE
 Why is off-model information
relevant?
• Not all information in the forecast can be
given by one model.
Eg informal judgement gives the best short-
term forecast (up to 6 months?)
 Why is a model important?
• The model gives consistency- help to explain
why the forecast was wrong
• The model gives a long-run forecast
• The model is needed to explain scenarios, risks
• The model can decompose past errors
• The model/forecast process is needed to provide
a common language, esp. within the CB
 CB forecast strategy
Could be characterised by:
• A crucial role for off-model info (judgement, small
models etc);
• transparency as a criteria for model design;
• the forecast as the MPC’s forecast;
• a medium-term forecasting model in the centre,
surrounded by satellites;
• and an emphasis on explaining uncertainty and past
error.
Current RPIX inflation projection based on
constant nominal interest rates at 5.0%
Percentage increase in prices on a year earlier
5

2.5

1995 96 97 98 99 2000 01
 Some Helpful Procedures

• Routinely produce forecasts of the data in the

form that is enters the policy debate (eg the
savings ratio)
• Record recent implicit residuals
• Record and decompose forecast errors
• Encourage sectoral analysts to forecast
 THE TIMETABLE
Inflation The
Report Forecast

- 6 weeks Issues Meeting

- 5 weeks 1st draft

- 4 weeks 2nd draft 1st meeting with

MPC on assumptions & risks

- 3 weeks 2nd meeting with MPC on

assumptions
- 2 weeks 3rd draft to MPC 3rd /4th meeting with MPC
- on first draft of forecast
- 1 week 4th draft 5th/6th meeting with MPC on
draft forecast
Conclusions finalised Forecast signed off

Publication
The end
Spare slides
 What is the Fan Chart?
• It is a subjective probability distribution of
likely outcomes for inflation and output
growth
• It explicitly allows for policy makers
subjective judgments about:
– the central estimates
– the uncertainty (variance)
– the risks (asymmetry) of possible outcomes
 How is the Fan Chart Constructed?

• Steps in the forecast process:

– a) Decide on the most likely outcomes through
a detailed discussion of forecast assumptions
– b) Decide on the degree of uncertainty over the
forecast period
– c) Decide on the balance of risks around the
most likely outcome
• Combined this information in a Fan Chart
 How Uncertain is the Future?
• We use forecast errors from the previous 10 years
– May be able to use other countries as a benchmark, use
a shorter sample period
• Errors are adjusted to include policy makers
judgments about future uncertainty relative to the
past
– For example: Central bank independence may reduce
the variance of inflation expectations relative to the
past
 What About the Risks?
• Come as a natural extension to the discussion
of the ‘most likely outcome’
– part of the forecast process and language
• The decision to include/exclude risks is
entirely judgmental
– What about asset prices?
• Key Question: If our central view is wrong
will it be more on the upside or the downside?
 Summary of Construction
• Three key steps:
– Need to form a view about the central
assumptions/outcome
– Make a judgment about the degree of
uncertainty relative to the past
– Make a judgment about the balance of risks
around the central assumption
 Example - Equity Prices
“The Committee has raised the central projection for world
activity in successive Reports as the global recover has
gathered pace. However, there remain a number of risks to
the projection, and the Committee continues to judge that
the risks to activity are weighted to the downside. A
sharper-than-expected slowdown in the United States,
perhaps in response to a marked fall in equity prices, is one
such risk.“

May 2000 Inflation Report, p50-51

 Functional Form of Distribution
• Two-piece normal distribution
• Collapses to normal if risks balanced
– hence it has many of the features of a normal
• Smooth, continuous, tractable
• Intuitively can be thought of as two halves of
2 normal distributions with different variance
– Distributions scaled to give equal mode
– Join at the mode (mean) to give one continuous
function with integral of unity
 Probability Density Function
 1  2  x  
2
 2   x         x     
1  2   x    
pdf  A * e
2  2

A  1
2
Where;
 
1  1 1 
 Some Properties
PS 
 E ( x)   
sd ( x)

E (x)   
     1     1   1    
2
 2      

 
   2 

var(x)  1   
    1     1 
 


 
 1   1    

mu is the mode, sigma is the input variance and gamma

is a parameter that relates to the skew
Background (1): the search for a nominal
anchor
Cross-Sectional distribution of inflation rates in
91 economies, 1970 to '98 Percentiles in
Cross-sectional
distribution
90
Inflation, % change on year earlier

80
95th
70
90th
60
80th
50
70th
40
30 median
20 30th
10 10th
0 5th
-10 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
 Israel…..

Inflation, Inflation Targets and Inflation Expectations

18%
CPI change,
16% 12 month ahead market-based
year over year
inflation expectations
14% 1992 target
12%
1997/8 target
10%
8% 1995 target
1993 target 1996 target
6% 1994 target
4%
1999 target
2%
1992 92 93 93 94 94 95 95 96. 96 97 97 98 98 99 99
Chile...
Inflation and Inflation Targets in Chile (a)

1986
40.0%

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

Source: Landerretche
, Morande , and Schmidt-Hebbel (1998).
(a)
Target is set in September for the following calendar year
 RBA

In the Statement on the Conduct of Monetary Policy, issued in 1996, the Governor
and the Treasurer agreed that the appropriate target for monetary policy is to
achieve an inflation rate of 2-3 per cent on average, a rate sufficiently low that it
does not materially distort economic decisions in the community.
The inflation target is defined as a medium-term average rather than as a hard-
edged target band within which inflation is to be held at all times. This formulation
allows for the inevitable uncertainties that are involved in forecasting, and lags in
the effects of monetary policy on the economy. Experience in Australia and
elsewhere has shown that inflation is not amenable to fine-tuning within a narrow
band. The inflation target is, necessarily, forward-looking, as evidenced by the
operation of monetary policy since its introduction. This approach allows a role for
monetary policy in dampening the fluctuations in output over the course of the
business cycle. When aggregate demand in the economy is weak, for example,
inflationary pressures are likely to be diminishing and monetary policy can be
eased, which will give a short-term stimulus to economic activity.
Forecasting in an inflation-
targeting central bank
Lavan Mahadeva

Centre of Central Banking Studies

Bank of England

Presentation at the
Banco Central del Reserva del Perú
Lima, 2002