A Factor Model for Euro-area Short-term Inflation Analysis

Abstract

SummaryThis paper develops a factor model for forecasting inflation in the euro area. The model can handle variables with different timeliness, sample size and frequency. We show that the forecasts based on the factor model outperform naïve random walk forecasts, a hard to beat benchmark for euro area inflation forecasts in recent years, at horizons of and beyond nine months ahead. They are also comparable, in terms of accuracy, to the judgemental forecasts prepared in the context of the Eurosystem macroeconomic projection exercises. The factor model is therefore a very suitable tool to extract the signal on current and future euro area inflation from new data releases.

Forecasting Euro Area Inflation Using Targeted Predictors: Is Money Coming Back?

“…As for the euro area, empirical studies show that in the period preceding 2001 monetary indicators contain some information regarding future inflation (Gottschalk et al, 2000;Nicoletti-Altimari, 2001;Trecoci and Vega, 2002;Gerlach and Svensson, 2003). Many studies find a decline in the forecastability of euro area inflation as well as a diminished predictive power of monetary variables during the period of low inflation volatility between 2001 and the Great Recession (Alves et al, 2007;Lenza, 2008;Rua, 2012). There is also empirical research showing that the information content of monetary indicators in the euro area is better exploited when they are combined with other predictors of inflation (Scharnagl and Schumacher, 2007;Lenza, 2008;Fischer et al, 2009).…”

“…Many studies find a decline in the forecastability of euro area inflation as well as a diminished predictive power of monetary variables during the period of low inflation volatility between 2001 and the Great Recession (Alves et al, 2007;Lenza, 2008;Rua, 2012). There is also empirical research showing that the information content of monetary indicators in the euro area is better exploited when they are combined with other predictors of inflation (Scharnagl and Schumacher, 2007;Lenza, 2008;Fischer et al, 2009).…”

“…Many studies find a decline in the forecastability of euro area inflation as well as a diminished predictive power of monetary variables during the period of low inflation volatility between 2001 and the Great Recession (Alves et al, 2007;Lenza, 2008;Rua, 2012). Extending the end of the forecasting period to 2010, Dreger and Wolters (2014) find that the out-of-sample forecasting performance of a model with M3 growth is worse than the benchmark of an autoregressive process for inflation and models with excess liquidity, excess inflation and the spread.…”

“…There is also empirical research showing that the information content of monetary indicators in the euro area is better exploited when they are combined with other predictors of inflation. For example, Lenza (2008) evaluates the predictive power of money and credit aggregates for HICP inflation in the euro area using a bivariate model containing M3 and bivariate models containing factors capturing information from several real and nominal variables. He finds that monetary variables provide information about inflation at long horizons even after many alternative predictors have been considered.…”

“…3 On the one hand, this sequence of systematic forecasting errors suggests that forecasting inflation can be even more challenging in a low inflation environment. On the other hand, the increased volatility in inflation observed since 2008 suggests that it may be easier in the post-crisis period to outperform naïve benchmark forecasting models, which are particularly hard to beat during periods of low volatility (Atkeson and Ohanian, 2001;D'Agostino et al, 2006;Stock and Watson, 2007;Lenza, 2008;D'Agostino and Surico, 2012). 1980s 1990-1998 1999-2007 2008-2012 2013-2015 1980s 1990-1998 1999-2007 2008-2012 2013-2015 Moreover, the role of money as a predictor of inflation is likely to have recently increased as a result of the introduction of ECB's non-standard measures.…”