The Inflation Forecast Process at the Central Bank of Chile

The Inflation Forecast Process at the
Central Bank of Chile
Juan Pablo Medina
Head of Models and Forecasting
Central Bank of Chile
1
IADB, Washington, April 2011
Introduction and Motivation
The Role of forecasting at the Central Bank of Chile

Inflation targeting framework in Chile since early 90s
 Forecasted inflation at the target in the policy horizon

Full fledged inflation targeting regime since 2000 with an inflation
target of 3% and policy horizon of two years

Hence, monetary policy design relies heavily on forecasts:
 Inflation [*]
 GDP
 Aggregate demand, current account, exchange rate, and other
relevant financial variables.
 Inflation report contains analysis of the main macroeconomic
developments and forecasts of the main macro variables. Also, it
discusses the changes in the forecasts respect to past report.
3
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Agenda
1.
Introduction and Motivation
2.
The inflation forecast process at the Central Bank of Chile
3.
4

Short term forecast

Medium term forecast
Forecast and Analysis in the Inflation Report

Point forecast and fancharts

Changes in forecast since last report

Risk analysis. Example: Transmission of oil price shocks
IADB, Washington, April 2011
Inflation forecast process at the CBC

Different components in the CPI basket:
 Energy products (e.g. fuels, electricity), which can be regulated
 Food products perishable and not perishable
 Other regulated products (e.g. public services)
 The rest of products can be considered as an index of core
inflation

Different horizons for the forecast process:
 Short term: between1 to 2 quarters ahead
 Medium term: starting between 2 and 3 quarters ahead
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Inflation Forecast Process
Inflation forecast process: An Overview
Inputs: past CPIs, NER,
international prices (actual
and forecast), information
in regulated prices
Short term
Forecasts
(component level)
Judgment
Alternative
Forecast
Medium term
forecast
(Structural models)
Central Forecast:
GDP, Demand, CA,
Inflation (total and
core).
Other Inputs: SS and/or neutral values; other international
variables; labor market variables; short term forecasts of
domestic activity and demand; financial variables; exercises of
macroeconomic consistency
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Short term forecast for inflation

Components of the CPI basket
 Perishable foods: (i) fruits and vegetables (weight: 3%); (ii) meat
and fish (weight: 3,5%)
 Forecasts based on ARIMA models adjusted with specific news
about the supply and seasonality
 Fuels (weight: about 6%)
 Forecast based on information in the expected path of
international prices, the nominal exchange rate (NER), taxes and
the mechanics of the stabilization fund
 Regulated and indexed prices (weight: 15%) public services
 Forecast based on ARIMA models combined with news in the
regulation and taxes
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IADB, Washington, April 2011
Short term forecast for inflation (cont.)
 Rest of products = core CPI (weight: 72.5%) [IPCX1]
 Forecast based on ARIMA models combined with information on
the cyclical position of the economy, exchange pass-through,
pass-through of changes in other prices.
 Other definitions: IPCX = IPC - IPC Comb - IPC FV
9
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Medium Term Forecast
Medium term forecast are based on a macroeconomic models that
make an explicit connection among GDP, demand, exchange rate,
inflation and monetary policy rate
 Main ingredients of macro models:
 IS curve that explains aggregate demand and/or output gap based
on monetary policy rate and external conditions
 Phillips curve for core inflation that depends on output gap and
imported inflation
 Interest parity condition
 Taylor type rule for the monetary policy rate

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Why do we need a (semi) structural models?
They allow to perform analysis and policy evaluation
 The structure of the models generates forecasts with a “story telling”
 The estimation of several elasticities determines the intensity of
different channels of macroeconomic transmission
 More structural models (as DSGE) are better equipped to perform
counterfactual analysis to determines the transmission propagation of
several shocks

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The CBC has two main medium term macro
model






12
MAS
New Keynesian paradigm
 Prices and wages are rigid in the short run
 Inflation is determined by gap in costs
 Transmission of MP: interest rate affects
consumption, investment, and exchange
rate
Most
of
parameters
have
a
interpretation
MP policy follows a Taylor type rule
structural
Joint determination of all variables in general
equilibrium
Fiscal policy is explicitly modeled
Supply and demand factors are considered
explicitly in the GDP determination. Example: oil
is part of the consumption basket and is an input
for production
IADB, Washington, April 2011

MEP
New Keynesian paradigm
 Prices are rigid in the short run
 Inflation is determined by gap in output and
costs
 Transmission of MP: interest rate affects
output gap and exchange rate

Parameters are semi-structural

MP policy follows a Taylor type rule

Sequential determination: (i) medium term
variables (potential GDP, neutral interest rate,
etc); (ii) Phillips curve, IS, UIP, Taylor rule;
Forecasts and Analysis in the
Inflation Report
The structural models are used for a diagnostic of the
state of the economy, forecasts and risk analysis
scenarios

During the Inflation Report process we perform three types of
exercises:
 Discussion of main news since last report. Macro Models are used
to quantify the effects of these news.
 Central Forecast of main variables: GDP, inflation, MP rate,
exchange rate.
 Risk analysis scenarios. We use the impulse response function of
the models to evaluate the impact and transmission of alternative
internal and external scenarios
 Disclaimer: all these exercises are informed and presented to the
board, but the board decides the final forecast contained in the
inflation report.
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Medium term forecasts in the inflation report

15
Inputs:
 Parameters of the model (including steady state values)
 International
conditions (actual and forecast): prices of
commodities, international inflation, foreign interest rate,
sovereign spread, external demand
 Short term forecast for activity, demand and domestic prices by CPI
components (1 to 2 quarters ahead)
 Judgment because the models are imperfect, excluding ingredients
that can turn important in a particular moment (example: increase
in the lending spread in the second part of 2008 and synchronized
fall in industrial production in most countries)
IADB, Washington, April 2011
Fancharts (Inflation Report March 2011)
PIB
12
12
(variación porcentual anual)
10
10
10
8
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
-6
-6
04
05
06
07
08
09
10
11
12
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
04
05
16
06
07
08
09
10
11
12
IADB, Washington, April 2011
13
11
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
04
IPC
(variación porcentual anual)
11
IPCX
(variación porcentual anual)
11
05
06
07
08
09
10
11
12
13
Range of the fancharts communicates the
uncertainty of the point forecast

Intervals for
information:
the
fancharts
are
obtained
using
the
following
 Historical forecast errors to different horizons
 Stochastic simulation of the macro models to different horizons
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Changes in the forecast
IPC
IPCX
(variación porcentual anual)
(variación porcentual anual)
10
10
8
8
6
6
4
4
2
2
0
0
-2
-4
04
05
06
07
08
09
10
11
12
10
10
8
8
6
6
4
4
2
2
-2
0
0
-4
-2
-2
13
04
05
IPCX1
(variación porcentual anual)
07
08
09
10
11
12

IPC Combustibles
13
(variación porcentual anual)
10
10
30
30
8
8
20
20
6
6
10
10
4
4
0
2
2
-1 0
-1 0
0
0
-2 0
-2 0
-2
-2
-3 0
-3 0
04
05
06
07
08
09
Efectivo
Fuente: Banco Central de Chile
18
06
10
11
12
13
0
04
IPoM Marzo
05
06
07
08
09
10
11
12
13
IPoM Diciembre
Changes in the forecast (cont.)
IPC
IPCX
(variación porcentual anual)
(variación porcentual anual)
10
10
8
8
6
6
4
4
2
2
0
0
-2
-4
04
05
06
07
08
09
10
11
12
10
10
8
8
6
6
4
4
2
2
-2
0
0
-4
-2
-2
13
04
05
06
IPCX1
(variación porcentual anual)
08
09
10
11
12
13
IPC Combustibles
(variación porcentual anual)
10
10
30
30
8
8
20
20
6
6
10
10
4
4
0
2
2
-1 0
-1 0
0
0
-2 0
-2 0
-2
-2
-3 0
-3 0
04
05
06
07
08
09
Efectivo
Fuente: Banco Central de Chile
19
07
10
11
12
13
0
04
IPoM Marzo
05
06
07
08
09
10
11
12
13
IPoM Diciembre
Explaining forecasts
20

The structure of the model can helps to explain the forecasts

However, the structure of models can be imperfect to identify the
shocks properly. Example: increase in food prices since 2007.
 Models are adapted to include food prices as an exogenous factor.
IADB, Washington, April 2011
Core inflation decomposition (Dec 2008)
Factores de oferta internos
Precio alimentos
Factores de demanda internos
6.0
6.0
6.0
4.0
4.0
4.0
2.0
2.0
2.0
0.0
0.0
0.0
-2.0
-2.0
-2.0
-4.0
-4.0
-4.0
-6.0
-6.0
-6.0
1990
1994
1998
2002
2006
2010
1990
Shocks de PM
1994
1998
2002
2006
2010
1990
1994
Factores externos
6.0
6.0
4.0
4.0
2.0
2.0
0.0
0.0
-2.0
-2.0
-4.0
-4.0
1998
2002
2006
2010
Total
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-6.0
-6.0
1990
21
1994
1998
2002
2006
2010
-5.0
1990
1994
IADB, Washington, April 2011
1998
2002
2006
2010
1990
1994
1998
2002
2006
2010
Components of CPI inflation (inflation Report
March 2011)
10
C o m b u s tib les ( 5 ,7 %)
8
8
A lim en to s s in fr u tas y v er d u r as fr es c as ( 2 1 ,3 2 %)
F r u tas y v er d u r as fr es c as ( 2 ,9 0 %)
R es to ( 6 4 ,6 5 %)
6
6
' IPC T o tal
4
4
2
2
0
0
-2
-2
-4
-4
01
22
10
S er v ic io s Pú b lic o s ( 5 .4 3 %)
02
03
04
05
06
IADB, Washington, April 2011
07
08
09
10
11
12
13
Analysis. Example: Inspecting the mechanism
of transmission of oil price shocks
Response to oil price increase of 20% (base
calibration)
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
6. 0
6. 0
0. 5
0. 5
0. 2
0. 2
5. 0
5. 0
0. 4
0. 4
0. 1
0. 1
4. 0
4. 0
0. 3
0. 3
3. 0
3. 0
0. 2
0. 2
0. 1
0. 1
2. 0
2. 0
0. 1
0. 1
0. 0
0. 0
1. 0
1. 0
0. 0
0. 0
0. 0
0. 0
-0 .1
-1 .0
-0 .2
-1 .0
Año 1
Año 2
Año 3
Año 1
Año 2
-0 .1
-0 .1
-0 .1
-0 .1
-0 .2
-0 .2
-0 .2
Año 3
Año 1
Año 2
Año 3
TPMN
PIB
TCR
Porcentaje
Crecimiento Anual
Porcentaje
0. 1
0. 1
0. 1
0. 1
0. 0
0. 1
0. 1
0. 0
0. 0
-0 .1
-0 .1
0. 0
0. 0
-0 .1
-0 .1
-0 .1
-0 .1
-0 .2
-0 .2
-0 .1
-0 .1
-0 .1
-0 .1
-0 .3
-0 .3
-0 .2
-0 .2
-0 .2
-0 .2
-0 .4
-0 .4
-0 .2
-0 .2
-0 .2
-0 .2
-0 .5
-0 .5
-0 .3
-0 .3
Año 1
Año 2
Año 3
Año 1
Año 2
Base
24
-0 .1
Año 3
Año 1
0. 0
Año 2
Año 3
Same shock but with flexible prices implies a lower
reduction in GDP. Other real rigidities in allocation still
explain a fall in GDP
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
6. 0
6. 0
0. 5
0. 5
0. 2
0. 2
5. 0
5. 0
0. 4
0. 4
0. 1
0. 1
4. 0
4. 0
0. 3
0. 3
3. 0
3. 0
0. 2
0. 2
0. 1
0. 1
2. 0
2. 0
0. 1
0. 1
0. 0
0. 0
1. 0
1. 0
0. 0
0. 0
0. 0
0. 0
-0 .1
-1 .0
-0 .2
-1 .0
Año 1
Año 2
Año 3
Año 2
-0 .1
-0 .1
-0 .1
-0 .1
-0 .2
-0 .2
-0 .2
Año 3
Año 1
Año 2
Año 3
TPMN
PIB
TCR
Porcentaje
Crecimiento Anual
Porcentaje
0. 4
0. 4
0. 1
0. 1
0. 2
0. 2
0. 3
0. 3
0. 0
0. 0
0. 2
0. 2
0. 1
0. 1
0. 1
0. 1
0. 0
0. 0
0. 0
0. 0
-0 .1
-0 .1
-0 .2
-0 .2
-0 .3
-0 .3
-0 .1
-0 .1
-0 .2
-0 .2
-0 .4
-0 .3
-0 .3
-0 .5
Año 1
Año 2
Año 3
Base
25
Año 1
-0 .1
Año 1
Año 2
Año 3
-0 .1
-0 .1
-0 .4
-0 .2
-0 .2
-0 .5
-0 .3
-0 .3
Año 1
Flexible prices
Año 2
Año 3
Same shock but with flexible prices and removing
real rigidities generate almost no effect in GDP.
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
6. 0
6. 0
0. 5
0. 5
0. 2
0. 2
5. 0
5. 0
0. 4
0. 4
0. 1
0. 1
4. 0
4. 0
0. 3
0. 3
3. 0
3. 0
0. 2
0. 2
0. 1
0. 1
2. 0
2. 0
0. 1
0. 1
0. 0
0. 0
1. 0
1. 0
0. 0
0. 0
0. 0
0. 0
-0 .1
-1 .0
-0 .2
-1 .0
Año 1
Año 2
Año 3
Año 2
-0 .1
-0 .1
-0 .1
-0 .1
-0 .2
-0 .2
-0 .2
Año 3
Año 1
Año 2
Año 3
TPMN
PIB
TCR
Porcentaje
Crecimiento Anual
Porcentaje
0. 1
0. 1
0. 1
0. 1
0. 4
0. 4
0. 1
0. 1
0. 0
0. 0
0. 3
0. 3
0. 0
0. 0
-0 .1
-0 .1
0. 2
0. 2
-0 .1
-0 .1
-0 .2
-0 .2
0. 1
0. 1
-0 .1
-0 .1
-0 .3
-0 .3
0. 0
0. 0
-0 .2
-0 .2
-0 .4
-0 .2
-0 .2
-0 .5
Año 1
Año 2
Año 3
Base
26
Año 1
-0 .1
Año 1
Año 2
Año 3
-0 .1
-0 .1
-0 .4
-0 .2
-0 .2
-0 .5
-0 .3
-0 .3
Año 1
Año 2
Año 3
Flexible prices and no real rigidities
Same shock in an estimated VAR from 2000s shows
propagation to other prices. Role of inflation
expectation.
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
1 5 .0
1 5 .0
3. 0
3. 0
1 0 .0
1 0 .0
2. 0
2. 0
5. 0
5. 0
1. 0
1. 0
0. 0
0. 0
0. 0
0. 0
-5 .0
-1 0.0
Año 1
Año 2
-5 .0
-1 .0
-1 .0
-1 0.0
-2 .0
-2 .0
Año 3
Año 1
Año 2
Año 3
TPMN
PIB
Porcentaje
Crecimiento Anual
2. 0
2. 0
2. 0
1. 0
1. 0
1. 0
1. 0
0. 0
0. 0
0. 0
0. 0
-1 .0
-2 .0
-2 .0
-3 .0
-3 .0
Año 1
Año 2
Año 3
-1 .0
-1 .0
-2 .0
-2 .0
-3 .0
-3 .0
-4 .0
-4 .0
Año 1
Año 2
Año 3
VAR
27
1. 0
0. 5
0. 5
0. 0
0. 0
-0 .5
-0 .5
-1 .0
-1 .0
Año 1
2. 0
-1 .0
1. 0
Año 2
Año 3
Propagation of oil price increase may be more intense
• Empirical evidence show an important propagation of oil price rise
during the 2000s.
• Higher propagation can reflect: (i) more sensitivity of energy to oil; (ii)
more pass-through to core inflation due to booming demand, more
wage rigidity or a rise in inflation expectation.
• We consider two alternatives cases:
•
More wage rigidity
• Rise in inflation expectation of 0,3% together with the increase of
20% in oil price
28
More wage rigidity exacerbates propagation
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
6. 0
6. 0
1. 2
1. 2
5. 0
5. 0
1. 0
1. 0
4. 0
4. 0
0. 8
0. 8
3. 0
3. 0
0. 6
0. 6
2. 0
2. 0
0. 4
0. 4
1. 0
1. 0
0. 2
0. 2
0. 0
0. 0
0. 0
0. 0
-1 .0
Año 1
-1 .0
Año 2
Año 3
Año 1
-0 .2
Año 2
Año 3
Año 1
0. 6
0. 5
0. 4
0. 3
0. 2
0. 1
0. 0
-0 .1
-0 .2
Año 2
Año 3
TPMN
PIB
TCR
Porcentaje
Crecimiento Anual
Porcentaje
0. 8
0. 8
0. 1
0. 1
0. 6
0. 6
0. 6
0. 6
0. 0
0. 0
0. 4
0. 4
0. 2
0. 2
0. 0
0. 0
0. 4
0. 4
0. 2
0. 2
0. 0
0. 0
-0 .1
-0 .1
-0 .2
-0 .2
-0 .3
-0 .3
-0 .4
-0 .4
-0 .2
-0 .2
-0 .2
-0 .2
-0 .5
-0 .5
-0 .4
-0 .4
-0 .4
-0 .4
-0 .6
-0 .6
-0 .6
-0 .6
Año 1
Año 2
Año 3
Base
29
-0 .2
0. 6
0. 5
0. 4
0. 3
0. 2
0. 1
0. 0
-0 .1
-0 .2
Año 1
Año 2
Año 3
Año 1
Año 2
More wage rigidty
Año 3
Same shock and an increase in inflation expectation
magnifies the propagation
IPC Energía
IPC Subyacente
Expectativas de Inflación
Crecimiento Anual
Crecimiento Anual
1 año hacia adelante
6. 0
6. 0
1. 2
1. 2
5. 0
5. 0
1. 0
1. 0
4. 0
4. 0
0. 8
0. 8
3. 0
3. 0
0. 6
0. 6
2. 0
2. 0
0. 4
0. 4
1. 0
1. 0
0. 2
0. 2
0. 0
0. 0
0. 0
0. 0
-1 .0
Año 1
-1 .0
Año 2
Año 3
Año 1
-0 .2
Año 2
Año 3
Año 1
0. 6
0. 5
0. 4
0. 3
0. 2
0. 1
0. 0
-0 .1
-0 .2
Año 2
Año 3
TPMN
PIB
TCR
Porcentaje
Crecimiento Anual
Porcentaje
0. 8
0. 8
0. 1
0. 1
0. 6
0. 6
0. 6
0. 6
0. 0
0. 0
0. 4
0. 4
0. 2
0. 2
0. 0
0. 0
0. 4
0. 4
0. 2
0. 2
0. 0
0. 0
-0 .1
-0 .1
-0 .2
-0 .2
-0 .3
-0 .3
-0 .4
-0 .4
-0 .2
-0 .2
-0 .2
-0 .2
-0 .5
-0 .5
-0 .4
-0 .4
-0 .4
-0 .4
-0 .6
-0 .6
-0 .6
-0 .6
Año 1
Año 2
Año 3
Base
30
-0 .2
0. 6
0. 5
0. 4
0. 3
0. 2
0. 1
0. 0
-0 .1
-0 .2
Año 1
Año 2
Año 3
Año 1
Año 2
Año 3
Increase in inflation expectation
The Inflation Forecast Process at the
Central Bank of Chile
Juan Pablo Medina
Head of Models and Forecasting
Central Bank of Chile
31
IADB, Washington, April 2011