Forecasting UK Inflation Bottom Up

38 Pages Posted: 6 Apr 2021 Last revised: 28 Sep 2022

See all articles by Andreas Joseph

Andreas Joseph

Bank of England

Galina Potjagailo

Bank of England

Eleni Kalamara

King’s College London; European Central Bank (ECB)

Chiranjit Chakraborty

Bank of England

George Kapetanios

King's College, London

Date Written: March 26, 2021

Abstract

We forecast CPI inflation in the United Kingdom up to one year ahead using a large set of monthly disaggregated CPI item series and a wide set of forecasting tools, including dimensionality reduction techniques, shrinkage methods, and non-linear machine learning models. We find that over the full sample period 2002–21, the Ridge regression combined with CPI item series yields substantial improvement against an autoregressive benchmark at the six-month horizon, whereas the benchmark is hard to beat with other models and for other horizons. However, when considering periods of time where aggregate CPI inflation measures exhibit changes in momentum (rising or falling) or tail values, a wide range of models leads to substantial significant relative forecast gains. Exploiting CPI items through shrinkage methods yields strongest gains at horizons of 6–12 months when headline and core inflation measures are rising or falling. At shorter horizons and when inflation is rising, machine learning tools combined with CPI items and macroeconomic indicators are more useful. We also provide a model-agnostic approach based on model Shapley value decompositions to interpret and communicate signals from groups of items according to interpretable CPI categories.

Keywords: Inflation, forecasting, machine learning, state space models, CPI disaggregated data, Shapley values

JEL Classification: C32, C45, C53, C55, E37

Suggested Citation

Joseph, Andreas and Potjagailo, Galina and Kalamara, Eleni and Chakraborty, Chiranjit and Kapetanios, George, Forecasting UK Inflation Bottom Up (March 26, 2021). Bank of England Working Paper No. 915, Available at SSRN: https://ssrn.com/abstract=3819286 or http://dx.doi.org/10.2139/ssrn.3819286

Andreas Joseph (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Galina Potjagailo

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Eleni Kalamara

King’s College London ( email )

Strand
London, England WC2R 2LS
United Kingdom

European Central Bank (ECB)

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Chiranjit Chakraborty

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

George Kapetanios

King's College, London ( email )

30 Aldwych
London, WC2B 4BG
United Kingdom
+44 20 78484951 (Phone)

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