Assessing the Economic Value of Probabilistic Forecasts in the Presence of an Inflation Target

45 Pages Posted: 29 Jun 2016

See all articles by Christopher McDonald

Christopher McDonald

Reserve Bank of New Zealand

Craig Thamotheram

University of Cardiff

Shaun P. Vahey

University of Warwick - Warwick Business School

Elizabeth C. Wakerly

University of East Anglia (UEA) - School of Economic and Social Studies

Date Written: June 27, 2016

Abstract

We consider the fundamental issue of what makes a “good” probability forecast for a central bank operating within an inflation targeting framework. We provide two examples in which the candidate forecasts comfortably outperform those from benchmark specifications by conventional statistical metrics such as root mean squared prediction errors and average logarithmic scores. Our assessment of economic significance uses an explicit loss function that relates economic value to a forecast communication problem for an inflation targeting central bank. We analyse the Bank of England’s forecasts for inflation during the period in which the central bank operated within a strict inflation targeting framework in our first example. In our second example, we consider forecasts for inflation in New Zealand generated from vector autoregressions, when the central bank operated within a flexible inflation targeting framework. In both cases, the economic significance of the performance differential exhibits sensitivity to the parameters of the loss function and, for some values, the differentials are economically negligible.

Keywords: Forecasting inflation, Inflation targeting, Cost-loss ratio, Forecast evaluation, Monetary policy

Suggested Citation

McDonald, Christopher and Thamotheram, Craig and Vahey, Shaun P. and Wakerly, Elizabeth C., Assessing the Economic Value of Probabilistic Forecasts in the Presence of an Inflation Target (June 27, 2016). CAMA Working Paper No. 40/2016 , Available at SSRN: https://ssrn.com/abstract=2801414 or http://dx.doi.org/10.2139/ssrn.2801414

Christopher McDonald

Reserve Bank of New Zealand ( email )

2 The Terrace
PO Box 2498
Wellington, 6140
New Zealand

Craig Thamotheram

University of Cardiff ( email )

Shaun P. Vahey (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Elizabeth C. Wakerly

University of East Anglia (UEA) - School of Economic and Social Studies ( email )

Norwich, Norfolk NR4 7TJ
United Kingdom

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