Forecasting Inflation with Gradual Regime Shifts and Exogenous Information

47 Pages Posted: 29 Jul 2011

See all articles by Kirstin Hubrich

Kirstin Hubrich

Board of Governors of the Federal Reserve System

Timo Terasvirta

Aarhus University - CREATES

Andres Gonzalez


Date Written: July 12, 2011


We propose a new method for medium-term forecasting using exogenous information. We first show how a shifting-mean autoregressive model can be used to describe characteristic features in inflation series. This implies that we decompose the inflation process into a slowly moving nonstationary component and dynamic short-run fluctuations around it. An important feature of our model is that it provides a way of combining the information in the sample and exogenous information about the quantity to be forecast. This makes it possible to form a single model-based inflation forecast that also incorporates the exogenous information. We demonstrate, both theoretically and by simulations, how this is done by using the penalised likelihood for estimating the model parameters. In forecasting inflation, the central bank inflation target, if it exists, is a natural example of such exogenous information. We illustrate the application of our method by an out-of-sample forecasting experiment for euro area and UK inflation. We find that for euro area inflation taking the exogenous information into account improves the forecasting accuracy compared to that of a number of relevant benchmark models but this is not so for the UK. Explanations to these outcomes are discussed.

Keywords: Nonlinear forecast, nonlinear model, nonlinear trend, penalised likelihood, structural shift, time-varying parameter

JEL Classification: C22, C52, C53, E31, E47

Suggested Citation

Hubrich, Kirstin and Terasvirta, Timo and Gonzalez, Andres, Forecasting Inflation with Gradual Regime Shifts and Exogenous Information (July 12, 2011). ECB Working Paper No. 1363. Available at SSRN:

Kirstin Hubrich (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Timo Terasvirta

Aarhus University - CREATES ( email )

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C

Andres Gonzalez


No Address Available

Register to save articles to
your library


Paper statistics

Abstract Views
PlumX Metrics