Time Horizons and Smoothing in the Bank of England's Reaction Function: The Contrast Between the Standard GMM and Ex Ante Forecast Approaches*

The monetary policy reaction function of the Bank of England is estimated by the standard GMM approach and the ex ante forecast method developed by Goodhart (2005) , with particular attention to the horizons for inflation and output at which each approach gives the best fit. The horizons for the ex ante approach are much closer to what is implied by the Bank's view of the transmission mechanism, while the GMM approach produces an implausibly slow adjustment of the interest rate, and suffers from a weak instruments problem. These findings suggest a strong preference for the ex ante approach.     

Leading Indicators for Euro‐area Inflation and GDP Growth*

In this paper, we evaluate the role of a set of variables as leading indicators for Euro‐area inflation and GDP growth. Our leading indicators are taken from the variables in the European Central Bank's (ECB) Euro‐area‐wide model database, plus a set of similar variables for the US. We compare the forecasting performance of each indicator ex post with that of purely autoregressive models. We also analyse three different approaches to combining the information from several indicators. First, ex post, we discuss the use as indicators of the estimated factors from a dynamic factor model for all the indicators. Secondly, within an ex ante framework, an automated model selection procedure is applied to models with a large set of indicators. No future information is used, future values of the regressors are forecast, and the choice of the indicators is based on their past forecasting records. Finally, we consider the forecasting performance of groups of indicators and factors and methods of pooling the ex ante single‐indicator or factor‐based forecasts. Some sensitivity analyses are also undertaken for different forecasting horizons and weighting schemes of forecasts to assess the robustness of the results.     

Can Germany save itself from negative rates?

• German inflation looks set to rise in response to diminishing slack in the economy. But this will be a mixed blessing for those in Germany hit by negative policy rates and ECB asset purchases. Higher German inflation may eliminate the need for further ECB policy action, but it is unlikely to trigger imminent rate hikes. As a result, the rise in inflation will merely lower real interest rates for German savers.
• Structural cross‐country differences mean that the ECB is better able to hit its inflation target when the peripheral economies rather than Germany are the region's growth engine. A key reason for this is that the German Phillips curve is flat by Eurozone standards, meaning that policymakers need to work hard to generate sufficient inflation in Germany to offset sustained weakness elsewhere.
• Despite this, there is evidence to suggest that the tightening labour market is beginning to push German wage growth higher. And if productivity growth remains subdued, this will lead to faster unit labour cost growth.
• While firms could respond by lowering their margins, the strength of household spending suggests that firms may be more inclined than in the past to pass on higher costs to consumers.
• In all, we expect German inflation to rise more sharply than elsewhere to around 2% in 2017, meaning that the ECB will not unveil further unconventional policy support. But it would take much sharper rises in German wage growth and inflation than in our baseline forecast to prompt the ECB to bring forward interest rate rises.

     

P-star in times of crisis – Forecasting inflation for the euro area

In this paper we present three empirically testable versions of the common p-star model and evaluate their forecasting performance using conventional techniques. We try to answer the question if the p-star approach is preferable to achieve a reliable short-run inflation forecast and with regard to the latter we incur the need for a stable demand for money function. Our findings indicate the recurrence of the relevance of the monetary pillar of the ECB's two-pillar framework. In addition, we check for the effects of the current financial and economic crisis that started in 2007 on the forecasting performance, using two sub-sample periods, one excluding and one including the latter, and analyze the impact of the applied filter technique to compute the required equilibrium values.     

Weak Identification of Forward‐looking Models in Monetary Economics*

Recently, single‐equation estimation by the generalized method of moments (GMM) has become popular in the monetary economics literature, for estimating forward‐looking models with rational expectations. We discuss a method for analysing the empirical identification of such models that exploits their dynamic structure and the assumption of rational expectations. This allows us to judge the reliability of the resulting GMM estimation and inference and reveals the potential sources of weak identification. With reference to the New Keynesian Phillips curve of Galí and Gertler [Journal of Monetary Economics (1999) Vol. 44, 195] and the forward‐looking Taylor rules of Clarida, Galí and Gertler [Quarterly Journal of Economics (2000) Vol. 115, 147], we demonstrate that the usual ‘weak instruments’ problem can arise naturally, when the predictable variation in inflation is small relative to unpredictable future shocks (news). Hence, we conclude that those models are less reliably estimated over periods when inflation has been under effective policy control.     

Lattice structure of knowledge and agreeing to disagree

This paper is a contribution to the study of the underlying mathematical structure of common-knowledge, which gives the well-known result of Aumann about the impossibility of ‘agreeing to disagree’. We present the Bayesian subjective probability model with player's belief: i.e. a triple (? %plane1D;4AF;, μ), in which i is a player. ? is a lattice in the field of sets of a state space Ω, %plane1D;4AF;, is a correspondence assigning to each state ω a filter %plane1D;4AF;(ω) in ?, and μ is a common-prior. For this model, we impose none of the important restrictions on the information structure in the Aumann-Bacharach model: axiom of knowledge K₁. axiom of transparency K₂ and axiom of wisdom K₃. We can extend both the disagreement theorem of Aumann and the agreement theorem of Geanacoplos and Polemarchakis under the assumption that each ? is an Artinian lattice.     

Does money help predict inflation? An empirical assessment for Central Europe

This paper investigates the predictive ability of money for future inflation in the Czech Republic, Hungary, Poland and Slovakia. We construct monetary indicators similar to those the European Central Bank regularly uses for monetary analysis. We find in-sample evidence that money matters for future inflation at the policy horizons that central banks typically focus on, but our pseudo out-of-sample forecasting exercise shows that money does not in general improve the inflation forecasts vis-à-vis some benchmark models such as the autoregressive process. Since at least some models containing money improve the inflation forecasts in certain periods, we argue that money still serves as a useful cross-check for monetary policy analysis.     

Macroeconomic and financial stability in a monetary union: The case of Lithuania

In this paper, we study the implications of macroprudential policies in a monetary union for macroeconomic and financial stability. For this purpose, we develop a two-country monetary union new Keynesian general equilibrium model with housing and collateral constraints, to be calibrated for Lithuania and the rest of the euro area. We consider two different scenarios for macroprudential policies: one in which the ECB extends its goals to also include financial stability and a second one in which a national macroprudential authority uses the loan-to-value ratio (LTV) as an instrument. The results show that both rules are effective in making the financial system more stable in both countries, and especially in Lithuania. This is because the financial sector in this country is more sensitive to shocks. We find that an extended Taylor rule is indeed effective in reducing the volatility of credit, but comes with a cost in terms of higher inflation volatility. The simple LTV rule, on the other hand, does not compromise the objective of monetary policy. This reinforces the “Tinbergen principle”, which argues that there should be two different instruments when there are two different policy goals.     

Inflation illusion and the Taylor principle: An experimental study

We develop a simple experimental setting to evaluate the role of the Taylor principle, which holds that the nominal interest rate has to respond more than one-for-one to fluctuations in the inflation rate to exert a stabilizing effect. In our setting, the average inflation rate fluctuates around the inflation target if the computerized central bank obeys the Taylor principle. If the Taylor principle is violated, the average inflation rate persistently deviates from the target. These deviations from the target are less pronounced, if inflation rates cannot be as readily observed as nominal interest rates. This result is consistent with the interpretation that subjects underestimate the influence of inflation on the real return to savings if the inflation rate is only observed ex post.     

Revisiting the Eurozone Phillips curve

• In a recent speech, ECB chief economist Peter Praet emphasised the importance of the Phillips curve ‐ the inverse relationship between unemployment and inflation ‐ when addressing concerns that disinflation (or even deflation) could become a longer‐term problem in the Eurozone. Praet argued that a scenario of a sustained period of disinflation is only realistic if the link between economic slack and inflation is broken. In this article, we revisit the Phillips curve in the Eurozone with the aim of gauging whether there has been a change in the relationship following the global financial crisis and how uniform the curve is among major Eurozone economies.
• We conclude that the Phillips curve is still valid in the Eurozone, although our analysis indicates a weakening of the link in the post‐crisis period. On the whole, our analysis shows that the Phillips curve relationship has been robust in the Eurozone since the creation of the currency union. However, in replicating the analysis for just the pre‐crisis period, we have noticed that the relationship between slack and inflation for the Eurozone was stronger (i.e. the slope of the curve was steeper) before the crisis rather than over the whole sample, since the introduction of the Euro.
• We find that there is considerable heterogeneity in the strength of the link between inflation and slack across the Eurozone economies, which adds to our existing body of work on their different responses to same shocks. Moreover, in contrast to the Eurozone overall, we find that in Spain and Italy the responsiveness of inflation to slack appears to have actually increased since the crisis; this might reflect the effectiveness of the structural reforms undertaken in both countries in order to reduce the rigidity of their economies.
• From 2014 onwards, very low inflation in the Eurozone has led to fears of sustained disinflation and even a deflationary spiral. Our view has always been that these fears were overblown; proving that the key structural relationship needed for ECB to meet its mandate is still in place corroborates our stance. Our forecast is for headline inflation to rise to 0.7% in 2016 (under the assumption that oil prices average US$37pb) and then to 1.7% in 2017 ‐ in line with ECB's target of “close to, but below, 2%”. The Phillips curve we have derived for the Eurozone tells a similar story. However, renewed weakness in oil prices at the start of 2016 presents a downside risk to our forecasts.
• Our bottom‐up CPI inflation model indicates that inflation might average just 0.2% this year if oil remains at around US$30pb. Furthermore, the prospect of external demand weakness derailing the Eurozone recovery poses another risk. This has raised the possibility of further expansion of the ECB's QE programme. However, as we continue to see resilient domestic demand in 2016, our baseline case still remains that the ECB will make no additional substantial adjustments to its QE programme in the near term.

     

Will the Bank of England turn dovish?

• ? Short of a sharp slowdown in the economy and/or inflation expectations, or a no‐deal Brexit, we think that the Bank of England is unlikely to follow recent moves by the Fed and ECB in signalling cuts to interest rates.
• ? Admittedly, the BoE's guidance on rate rises has gone awry before. And the UK has some commonalities with the US and eurozone, including declining core inflation and continued job creation without inflationary consequences.
• ? But growth projections paint the UK in a relatively favourable light, while stable inflation expectations and a relaxation of fiscal austerity offer two more reasons for the BoE to plough its own, more hawkish, furrow.

     

Monetary Policy in the Greenspan Era: A Time Series Analysis of Rules vs. Discretion*

Relationships between the Federal funds rate, unemployment, inflation and the long‐term bond rate are investigated with cointegration techniques. We find a stable long‐term relationship between the Federal funds rate, unemployment and the bond rate. This relationship is interpretable as a policy target because deviations are corrected via the Federal funds rate. Deviations of the actual Federal funds rate from the estimated target give simple indications of discretionary monetary policy, and the larger deviations relate to special episodes outside the current information set. A more traditional Taylor‐type target, where inflation appears instead of the bond rate, does not seem congruent with the data.     

The Incremental Predictive Information Associated with Using Theoretical New Keynesian DSGE Models vs. Simple Linear Econometric Models*

In this paper we construct output gap and inflation predictions using a variety of dynamic stochastic general equilibrium (DSGE) sticky price models. Predictive density accuracy tests related to the test discussed in Corradi and Swanson [Journal of Econometrics (2005a), forthcoming] as well as predictive accuracy tests due to Diebold and Mariano [Journal of Business and Economic Statistics (1995) , Vol. 13, pp. 253–263]; and West [Econometrica (1996) , Vol. 64, pp. 1067–1084] are used to compare the alternative models. A number of simple time‐series prediction models (such as autoregressive and vector autoregressive (VAR) models) are additionally used as strawman models. Given that DSGE model restrictions are routinely nested within VAR models, the addition of our strawman models allows us to indirectly assess the usefulness of imposing theoretical restrictions implied by DSGE models on unrestricted econometric models. With respect to predictive density evaluation, our results suggest that the standard sticky price model discussed in Calvo [Journal of Monetary Economics (1983), Vol. XII, pp. 383–398] is not outperformed by the same model augmented either with information or indexation, when used to predict the output gap. On the other hand, there are clear gains to using the more recent models when predicting inflation. Results based on mean square forecast error analysis are less clear‐cut, although the standard sticky price model fares best at our longest forecast horizon of 3 years, it performs relatively poorly at shorter horizons. When the strawman time‐series models are added to the picture, we find that the DSGE models still fare very well, often outperforming our forecast competitions, suggesting that theoretical macroeconomic restrictions yield useful additional information for forming macroeconomic forecasts.     

Has the ECB increased interest rates too soon?

Even though the Eurozone recovery is far from entrenched, the ECB decided to raise interest rates towards the end of 2005 and another hike is expected soon. Those in the ECB who have been looking for a reason to start tightening for some time can point to an inflation rate that remains stubbornly above target as a justification. In this article we find that the price rises of non‐energy industrial goods ‐ particularly those for clothing and footwear ‐ have remained very sticky when compared to the deflation seen in countries like the UK. A lack of competitive forces may be an issue ‐ the impact of China and India on goods prices does not seem to be fully feeding through to consumers. And weak productivity in the distribution sector may have prevented retailers from driving down prices to the same extent as in the UK. Does the current ECB action form the start of a prolonged tightening cycle as seen in the US? Despite worries over asset price and credit growth ‐ and here we argue that the ECB's reliance on monetary aggregates as a signal of impending inflation is misguided ‐ there is a possibility that the ECB has acted at the same time that inflation is finally set to subside. Consequently, we expect a "wait and see" approach to further moves, and unless growth comes in much stronger than the 2.2% we expect in 2006, rates should end the year at around 2½%.     

Do Wall Street economists believe in Okun’s Law and the Taylor Rule?

We use data from the Wall Street Journal’s semi-annual survey of professional economists to test whether individual economists’ six-month-ahead predictions of real GDP growth, unemployment, short-term interest rates and inflation reflect Okun’s Law and the Taylor Rule. We conclude the economists believe real growth is less responsive to unemployment-rate changes than the textbook version of Okun’s Law; we also find the economists believe the Federal Reserve sets short-term interest rates by placing more weight on unemployment and less weight on inflation than the Taylor Rule prescribes.     

On the desirability of nominal GDP targeting

This paper evaluates the welfare properties of nominal GDP targeting in the context of a New Keynesian model with both price and wage rigidity. In particular, we compare nominal GDP targeting to inflation and output gap targeting as well as to a conventional Taylor rule. These comparisons are made on the basis of welfare losses relative to a hypothetical equilibrium with flexible prices and wages. Output gap targeting is the most desirable of the rules under consideration, but nominal GDP targeting performs almost as well. Nominal GDP targeting is associated with smaller welfare losses than a Taylor rule and significantly outperforms inflation targeting. Relative to inflation targeting and a Taylor rule, nominal GDP targeting performs best conditional on supply shocks and when wages are sticky relative to prices. Nominal GDP targeting may outperform output gap targeting if the gap is observed with noise, and has more desirable properties related to equilibrium determinacy than does gap targeting.     

World Economic Prospects

Overview: Global deflation – a genuine risk?

• The notable decline in inflation in the Eurozone, US and UK since mid-2013 has led to suggestions that a period of widespread price deflation across the major economies is a risk. Adding to these concerns has been the trajectory of producer prices – already declining in the Eurozone and China and showing very subdued growth elsewhere.
• Our global GDP forecasts do not, in isolation, point to a worldwide deflation risk. We expect growth at 2.8% this year and 3.2% next, little changed from last month.
• But the starting point for this growth matters, specifically the gap between actual and potential output last year. Even with reasonable growth, an initially large output gap would imply downward pressure on inflation over the next two years.
• Unfortunately, the size of the output gap is very uncertain. There is a wide range of estimates for the major economies, especially Japan. Part of the problem is that it is hard to know how much potential output was (or was not) permanently lost during the global financial crisis and recession.
• Assuming substantial permanent losses, output gaps might be relatively modest now, but a more optimistic view of the supply side of the economy would suggest output gaps could be quite large – and arguably this fits better with the recent evidence from inflation.
• Overall, while we see a genuine risk of deflation in the Eurozone (with around a 15% probability) we are more upbeat about the other major economies, where growth in the broad money supply and nominal GDP do not seem to be signaling deflation risks.
• But the difficulty of measuring ‘slack’ in the economy for us underlines the case for central banks to err on the side of caution when setting monetary policy, and either not tightening too soon or easing further. This month we have built in a further ECB rate cut to our Eurozone forecast. In Japan, we have revised down growth for 2014–15 with recent data strengthening the case for additional monetary easing this year.

     

Consistency of assessments in infinite signaling games

In this paper we investigate possible ways to define consistency of assessments in infinite signaling games, i.e. signaling games in which the sets of types, messages and answers are complete, separable metric spaces. Roughly speaking, a consistency concept is called appropriate if it implies Bayesian consistency and copies the original idea of consistency in finite extensive form games as introduced by ^{Kreps and Wilson (Econometrica 1982, 50, 863–894)}. We present a particular appropriate consistency concept, which we call strong consistency and give a characterization of strongly consistent assessments. It turns out that all appropriate consistency concepts are refinements of strong consistency. Finally, we define and characterize structurally consistent assessments in infinite signaling games.     

Financial reforms and money demand: Evidence from 20 developing countries

The effects of financial reforms on money demand (M1) are analysed with estimates for two sets of sub-samples and two break dates for twenty developing Asian and African countries. In all cases, the magnitude of income elasticity does not change significantly when compared with sub-samples and whole sample periods. Using CUSUM and CUSUMSQ tests, we find that the demand for money functions in our selected countries are temporally stable and therefore the respective monetary authorities may target money supply as the conduct of monetary policy.     

Nonlinearity in the Fed's monetary policy rule

This paper investigates the nature of nonlinearities in the monetary policy rule of the US Federal Reserve (Fed) using the flexible approach to nonlinear inference. We find that while there is significant evidence of nonlinearity for the period to 1979, there is little such evidence for the subsequent period. Possible asymmetries in the Fed's reactions to inflation deviations from target and the output gap in the 1960s and 1970s may tell part of the story, but do not capture the entire nature of the nonlinearity. The inclusion of the interaction between inflation deviations and the output gap, as recently proposed, appears to characterize the nonlinear policy rule more adequately. Copyright © 2005 John Wiley & Sons, Ltd.