Forecasting inflation with gradual regime shifts and exogenous information

Kirstin Hubrich, Andres Gonzalez and Timo Teräsvirta

No 1363, Working Paper Series from European Central Bank

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

Keywords: Nonlinear forecast; nonlinear model; nonlinear trend; penalised likelihood; structural shift; time-varying parameter (search for similar items in EconPapers)
Date: 2011-07
New Economics Papers: this item is included in nep-cba, nep-ets, nep-for and nep-mon
Note: 1325881
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Working Paper: Forecasting inflation with gradual regime shifts and exogenous information (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20111363

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