Backtesting the RPIX inflation fan charts

Kevin Dowd

Journal of Risk Model Validation

Abstract: ABSTRACT This paper provides a systematic evaluation of the forecasting performance of the Bank of England's RPIX inflation fan charts. The tests are carried out on forecast data that have gone through probability integral and then Berkowitz transformations to become standard normal under the null hypothesis that the Bank's forecasts are adequate. These transformations are carried out for each of nine forecast horizons. Except for the transformed series over the first (ie, current-period) forecast horizon, these series are not predicted to be independent. The key problem in testing is then how to deal with this dependence structure; three alternative approaches are suggested to deal with this problem: ignoring the dependence structure, positing an AR(1) dependence structure and positing an MA(k + 1) dependence structure. Results indicate that there are serious problems with the fan chart forecasts whichever approach we take to the dependence structure, and the results for the longer horizon forecasts are especially poor. There can therefore be little doubt that the fan chart forecasts perform badly, especially over longer forecast horizons.

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