Thursday, May 23, 2024

Navigating the Inflation Forecast Challenges: A Retrospective on Eurosystem/ECB Staff Projections Amid Global Crises


An update on the accuracy of recent Eurosystem/ECB staff projections for short-term inflation

The task of forecasting inflation has proven exceptionally difficult in recent years, given the unprecedented shocks that have impacted the euro area economy. From the COVID-19 pandemic to geopolitical tensions, such as Russia’s conflict with Ukraine, inflation has surged due to extraordinary events that have challenged traditional forecasting models. These shocks, mainly lying outside historical trends, have complicated the extrapolation of past patterns into future inflation predictions. In response, Eurosystem/ECB staff projections have begun to include alternative scenarios to better encapsulate the prevailing uncertainties.

Errors in short-term inflation projections notably increased in the latter half of 2021, only to see a significant reduction in 2023. Analysis conducted by the ECB in 2022 delved into the forecast performance deterioration noticed since mid-2021, while further examination in 2023 assessed the impacts of the Ukraine war and subsequent energy supply disturbances on projection accuracy during 2022. These findings highlighted substantial, broad-based projection errors, emphasizing the overwhelming influence of global factors, particularly in relation to the spikes in commodity prices. However, as 2022 progressed, the contribution of errors tied to energy prices or other assumptions declined, pointing instead towards the influence of other exceptional shocks on HICP inflation excluding food and energy (HICPX).

Recent analyses focus on the 2023 period, revealing that staff projection accuracy, particularly for HICP inflation, has largely returned to pre-pandemic levels, with HICPX inflation errors receding but still slightly above historical norms. Early data for 2024 suggest minimal forecast errors for HICP inflation, with HICPX projections aligning closely with observed outcomes.

Comparatively, inflation forecasts across various international and private institutions have also seen improved accuracy recently, aligning closely with Eurosystem/ECB staff predictions in both direction and magnitude of forecast errors for short-term inflation.

Examining the breakdown of projection errors reveals shifting dynamics over time. Initially dominated by energy prices, 2022 witnessed an unexpected rise in food prices contributing significantly to errors. By 2023, the rapid decline in energy prices emerged as a new source of significant projection error. Traditionally, technical assumptions about commodity prices, such as oil, explained most energy inflation forecasting errors. However, as gas prices increasingly diverged from oil prices, the complexity of energy price pass-through mechanisms became more pronounced, necessitating adjustments in projection models and assumptions.

A historical decomposition of HICPX inflation underscores the significant impact of indirect effects from energy price spikes and global supply chain disturbances. Remarkably, supply-side shocks constituted the majority of the post-pandemic rise in HICPX inflation, with demand shocks also playing a crucial role following the economy’s reopening. Despite these challenges, ECB staff continue to refine their forecasting toolkit, incorporating advanced models and techniques to ensure robust projections, particularly under conditions of high uncertainty.

This ongoing effort includes enhancing the modelling of gas prices and global supply chains, developing machine learning models to better capture non-linear dynamics, and employing a diverse set of tools for comprehensive risk assessment around baseline scenarios. Since March 2023, the introduction of fan charts in staff projections has vividly illustrated the inherent uncertainties, especially over longer horizons. These refinements and analyses form a critical component of the ECB’s monetary policy decision-making process, complementing baseline projections and contributing to a nuanced understanding of inflation dynamics.

Jordan Clark
Jordan Clark
Jordan Clark brings a dynamic and investigative approach to business reporting. Holding a degree in Business Administration and a certification in Data Analysis, Jordan has an eye for detail and a knack for uncovering the stories behind the numbers. His career began in the bustling world of Silicon Valley startups, giving him firsthand experience in tech entrepreneurship and venture capital. Jordan's reports often focus on technology's impact on business, startup culture, and emerging

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