Academic journal article The Reserve Bank of New Zealand Bulletin

The Reserve Bank's Forecasting Performance. (Articles)

Academic journal article The Reserve Bank of New Zealand Bulletin

The Reserve Bank's Forecasting Performance. (Articles)

Article excerpt

For most of the period since 1994, the target range for annual Consumers Price Index (CPI) inflation, established by the Policy Targets Agreements (PTA), was 0 to 3 per cent. Over this period, actual CPI inflation has averaged 2 per cent. As one might expect, analysis shows that our medium-term CPI inflation forecasts since 1994 have been biased towards under-prediction, which is the subject of this article.

In any particular period, inflation is unlikely to be exactly as forecast, given that the economy is affected by unforeseeable events and inflation is far from perfectly controllable. However, it is important to have a good understanding of why inflation has evolved as it has, and not as predicted. We need to know whether particular events in the period under consideration have dominated inflation outcomes, or whether there is a fundamental problem with the policy process -- such as a fundamental misunderstanding of the workings of the economy -- that would systematically affect future monetary policy outcomes unless corrected.

In this article we focus particularly on our CPI inflation forecasting performance, but also examine our forecasts of other key macroeconomic variables, given their relevance for explaining our CPI forecasts.

We conclude that, in the mid-1990s, underestimation of growth, and overestimation of the economy's capacity to grow without generating inflation pressures, were the source of most of our under-prediction of medium-term CPI inflation. From 1998 until recently, the major factor explaining the under-prediction of inflation appears to have been sizeable and persistent differences between the assumptions we used for the path of the exchange rate and its actual evolution.

We also conclude that contributions to forecast inaccuracies have at times been made by our understanding of the non-inflationary output growth rate, the equilibrium exchange rate and exchange rate pass-through into CPI inflation. However, these factors do not appear to be systematic sources of inflation forecast bias.

1 Introduction

Most macroeconomic forecasters periodically examine their forecast performance in order to check their understanding of the workings of the economy and improve their forecasting capacity. Central banks, in particular, continually review their projection methodology and performance within the context of its relevance for the effective operation of monetary policy. This article discusses the Reserve Bank's forecast performance over the past decade, with a particular focus on Consumers Price Index (CPI) inflation.

Optimal monetary policy is forward-looking, taking account of time lags before policy actions affect the economy. For this reason, most inflation-targeting central banks use projections to guide policy. We do likewise, but we are relatively unusual among central banks in two respects: we publish relatively complete economic projections that are tied quite closely to the current monetary policy decision, (1) and we allow for monetary policy to evolve in the future depicted within those projections.

The primary reason we publish such projections is their value as a communication tool. Our projections provide a sense of where we currently believe the economy is headed, but just as importantly, also provide a framework for communicating our understanding of relationships within the economy. The implications of emerging information can then be assessed by both the Bank and financial markets against a well-articulated benchmark, thereby reducing uncertainty about our likely actions.

However, projections are not the "be all and end all" of monetary policy, and are highly conditional on the information available at the time the forecasts are prepared. They are almost invariably 'wrong' in some sense, due to the complexity and ever-changing nature of the economy, and a constant procession of unforeseeable events, such as large oil price movements, world trade policy changes, and droughts. …

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