Forecasting inflation and tracking monetary policy in the euro area ...

Wo r k i n g Pa p e r S e r i e s N o 9 0 0 / M ay 2 0 0 8

Forecasting inflation and tracking monetary policy in the euro area does national information help?

by Riccardo Cristadoro, Fabrizio Venditti and Giuseppe Saporito

WO R K I N G PA P E R S E R I E S N O 9 0 0 / M AY 20 0 8

FORECASTING INFLATION AND TRACKING MONETARY POLICY IN THE EURO AREA DOES NATIONAL INFORMATION HELP? 1 by Riccardo Cristadoro 2, Fabrizio Venditti and Giuseppe Saporito

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This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1126670.

1 The views expressed in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the ECB or Banca d’Italia. 2 All authors: Banca d’Italia, Research Department, via Nazionale 91, I – 00184 Rome, Italy; email: [email protected], [email protected]; [email protected] (Cagliari Branch at Banca d’Italia).

© European Central Bank, 2008 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb. europa.eu/pub/scientific/wps/date/html/ index.en.html ISSN 1561-0810 (print) ISSN 1725-2806 (online)

CONTENTS Abstract

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Non-technical Summary

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1 Introduction

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2 Data and methodology 2.1 Data 2.1.1 Data transformation 2.1.2 Data Realignment 2.2 The econometric methodology 2.2.1 Direct and indirect core inflation measures 2.2.2 Smooth factors and core infaltion measures 2.2.3 Core inflation and forecasting

8 8 9 9 9

3 Dynamic Correlations and stylized facts 4 Forecasting euro area inflation: does national information help? 4.1 Alternative GDFM forecasting exercises: targeted predictors. 4.1.1 Commonality criterion 4.1.2 Threshold criterion 4.2 Results 4.2.1 Germany 4.2.2 France 4.2.3 Italy 4.2.4 Euro area 4.2.5 Does national information help in forcasting euro area inflation 4.3 Comments

11 11 12 12 14 15 15 15 16 17 17 17 17 18 18

5 The ECB reaction function: does national information matter? 5.1 The empirical strategy 5.2 Data issues

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6 Conclusions

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References

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Tables and figures

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European Central Bank Working Paper Series

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ECB Working Paper Series No 900 May 2008

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Abstract The ECB objective is set in terms of year on year growth rate of the Euro area HICP. Nonetheless, a good deal of attention is given to national data by market analysts when they try to anticipate monetary policy moves. In this paper we use the Generalized Dynamic Factor model to develop a set of core inflation indicators that, combining national data with area wide information, allow us to answer two related questions. The first is whether country specific data actually bear any relevance for the future path of area wide price growth, over and above that already contained in area wide data. The second is whether in order to track ECB monetary policy decisions it is useful to take into account national information and not only area wide statistics. In both cases our findings point to the conclusion that, once area wide information is properly taken into account, there is little to be gained from considering national idiosyncratic developments.

Keywords: forecasting, dynamic factor model, inflation, Taylor rule, monetary policy JEL Classification: C25, E37, E52

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Non-technical summary The ECB monetary policy objective of maintaining price stability in the euro area is defined in terms of the year on year rate of growth of the area wide Harmonized Index of Consumer Prices (HICP) over the medium run. Given the forward-looking nature of its objective, predicting inflation emerges as a crucial task both for the Central Bank, whose interest rates decisions respond to changes in expected price growth, and for analysts that want to track the ECB moves. An important issue that naturally arises in forecasting euro area inflation is how to deal with the availability of both aggregate and national information in an economic area where a centralized monetary policy coexists with a decentralized fiscal policy and segmented labour markets. In such a context looking at national data could in principle provide some additional information on future inflation, over and above that contained in area wide data. The aim of this paper is to assess the value added of national information to forecast euro area inflation and to track euro area interest rates. To gauge the predictive content of national variables we propose a set of core inflation indicators, computed using the Generalized Dynamic Factor Model, that combine both national and area wide data to predict inflation at different horizons. As a corollary to this approach, we also explore the issue recently raised in the related literature of whether “more data” in factor models is always “better”. To do so we report a careful analysis of different data-reduction methods and assess the gains in forecast accuracy arising from them. To assess whether national information is relevant for tracking monetary policy we proceed in two steps. First, we compare the forecasting performance of our core indicators with that of univariate models built with alternative predictors. In this context we also consider the potential gains of using national information as summarized by national core indexes or an area wide core measure estimated on a data set that does not include only area wide statistics. Second, we check whether one can “track” ECB monetary policy decision using the euro core index and the output gap, in a simple Taylor rule framework, and test whether national information helps in rationalizing interest rates developments. The main results of our analysis can be summarized as follows. x

Core inflation indexes based on common factors estimated on large datasets have good forecasting properties both for national and area wide inflation rates. Consistently with the ECB monetary policy objective we define our inflation forecast target as the twelve month rate of change of the Harmonized Index of Consumer Prices. When compared with simple univariate models or with simple regression models that use variables routinely scrutinized by the ECB Governing Council in their Monetary and Economic assessment, our core inflation indexes almost always provide the best signals for future inflation at the horizons relevant for monetary policy. The prediction of euro ECB Working Paper Series No 900 May 2008

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x

x

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area inflation does not improve when including national data in the information set. Furthermore the use of different selection criteria does not generally lead to more precise forecast than those obtained estimating the common factors on the full information set. The good forecasting performance of our core indicators allows us to consider them as natural candidates for analyzing interest rate behaviour in the euro area. We find that the core inflation index estimated on area wide data, together with a survey based output gap measure, contributes significantly to tracking short term interest rates movements. The use of national information, proxied by our national core inflation indexes, on the other hand, does not add any significant explanatory power to the baseline Taylor rule regression. We conclude that the area wide core inflation index appropriately summarizes all the relevant information, both for forecasting medium term inflation developments and for tracking the ECB monetary policy. Conditioning on area wide data, the use of national information turns out to be irrelevant for both aims.


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35

Correlation between the Survey output gap at time t and the 3-month-Euribor at time t+h 0.8 0.6

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36


European Central Bank Working Paper Series For a complete list of Working Papers published by the ECB, please visit the ECB’s website (http://www.ecb.europa.eu). 862 “Stock market volatility and learning” by K. Adam, A. Marcet and J. P. Nicolini, February 2008. 863 “Population ageing and public pension reforms in a small open economy” by C. Nickel, P. Rother and A. Theophilopoulou, February 2008. 864 “Macroeconomic rates of return of public and private investment: crowding-in and crowding-out effects” by A. Afonso and M. St. Aubyn, February 2008. 865 “Explaining the Great Moderation: it is not the shocks” by D. Giannone, M. Lenza and L. Reichlin, February 2008. 866 “VAR analysis and the Great Moderation” by L. Benati and P. Surico, February 2008. 867 “Do monetary indicators lead euro area inflation?” by B. Hofmann, February 2008. 868 “Purdah: on the rationale for central bank silence around policy meetings” by M. Ehrmann and M. Fratzscher, February 2008. 869 “The reserve fulfilment path of euro area commercial banks: empirical testing using panel data” by N. Cassola, February 2008. 870 “Risk management in action: robust monetary policy rules under structured uncertainty” by P. Levine, P. McAdam, J. Pearlman and R. Pierse, February 2008. 871 “The impact of capital flows on domestic investment in transition economies” by E. Mileva, February 2008. 872 “Why do Europeans work part-time? A cross-country panel analysis” by H. Buddelmeyer, G. Mourre and M. Ward, February 2008. 873 “The Feldstein-Horioka fact” by D. Giannone and M. Lenza, February 2008. 874 “How arbitrage-free is the Nelson-Siegel model?” by L. Coroneo, K. Nyholm and R. Vidova-Koleva, February 2008. 875 “Global macro-financial shocks and expected default frequencies in the euro area” by O. Castrén, S. Dées and F. Zaher, February 2008. 876 “Are sectoral stock prices useful for predicting euro area GDP?” by M. Andersson and A. D’Agostino, February 2008. 877 “What are the effects of fiscal policy shocks? A VAR-based comparative analysis” by D. Caldara and C. Kamps, March 2008. 878 “Nominal and real interest rates during an optimal disinflation in New Keynesian models” by M. Hagedorn, March 2008. 879 “Government risk premiums in the bond market: EMU and Canada” by L. Schuknecht, J. von Hagen and G. Wolswijk, March 2008. 880 “On policy interactions among nations: when do cooperation and commitment matter?” by H. Kempf and L. von Thadden, March 2008. ECB Working Paper Series No 900 May 2008

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881 “Imperfect predictability and mutual fund dynamics: how managers use predictors in changing systematic risk” by G. Amisano and R. Savona, March 2008. 882 “Forecasting world trade: direct versus “bottom-up” approaches” by M. Burgert and S. Dées, March 2008. 883 “Assessing the benefits of international portfolio diversification in bonds and stocks” by R. A. De Santis and L. Sarno, March 2008. 884 “A quantitative perspective on optimal monetary policy cooperation between the US and the euro area” by S. Adjemian, M. Darracq Pariès and F. Smets, March 2008. 885 “Impact of bank competition on the interest rate pass-through in the euro area” by M. van Leuvensteijn, C. Kok Sørensen, J. A. Bikker and A. A. R. J. M. van Rixtel, March 2008. 886 “International evidence on sticky consumption growth” by C. D. Carroll, J. Slacalek and M. Sommer, March 2008. 887 “Labor supply after transition: evidence from the Czech Republic” by A. Bičáková, J. Slacalek and M. Slavík, March 2008. 888 “House prices, money, credit and the macroeconomy” by C. Goodhart and B. Hofmann, April 2008. 889 “Credit and the natural rate of interest” by F. De Fiore and O. Tristani, April 2008. 890 “Globalisation, domestic inflation and global output gaps: evidence from the euro area” by A. Calza, April 2008. 891 “House prices and the stance of monetary policy” by M. Jarociński and F. Smets, April 2008. 892 “Identification of New Keynesian Phillips Curves from a global perspective” by S. Dées, M. H. Pesaran, L. V. Smith and R. P. Smith, April 2008. 893 “Sticky wages: evidence from quarterly microeconomic data” by T. Heckel, H. Le Bihan and M. Montornès, May 2008. 894 “The role of country-specific trade and survey data in forecasting euro area manufacturing production: perspective from large panel factor models” by M. Darracq Pariès and L. Maurin, May 2008. 895 “On the empirical evidence of the intertemporal current account model for the euro area countries” by M. Ca’Zorzi and M. Rubaszek, May 2008. 896 “The Maastricht convergence criteria and optimal monetary policy for the EMU accession countries” by A. Lipińska, April 2008. 897 “DSGE-modelling when agents are imperfectly informed” by P. De Grauwe, April 2008. 898 “Central bank communication and monetary policy: a survey of theory and evidence” by A. S. Blinder, M. Ehrmann, M. Fratzscher, J. De Haan and D.-J. Jansen, April 2008. 899 “Robust monetary rules under unstructured and structured model uncertainty” by P. Levine and J. Pearlman, April 2008. 900 “Forecasting inflation and tracking monetary policy in the euro area: does national information help?” by R. Cristadoro, F. Venditti and G. Saporito, May 2008.

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