Thursday, 15 November 2012

The Prophetical Talents of the Central Bank of Iceland

The Central Bank of Iceland upped its policy rates by 25 points yesterday to 6.0%. Quite frankly, I think they made a bad situation worse by doing so when it comes to the outflow of capital out of the economy and the exchange rate of the krona. But that's another story that I'm going to analyse later.

For now, I'm only going to update the graph that I first posted in The Predictability of Inflation Forecasts. Again, we can see that the inflation forecasts issued by the Central Bank of Iceland are still the same: take the current inflation rate and slowly diminish it towards the inflation target, i.e. 2.5%. No matter the rate of inflation today, it will always be down to the inflation target, or thereabouts, in 6-8 quarters (a phenomenon first pointed out by Fridrik Mar Baldursson at the University of Reykjavik). You seriously couldn't make this thing up!

The Quarterly Macroeconomic Model of the Central Bank of Iceland always predicts that the rate of inflation will move towards the inflation target in 8 quarters or so, no matter the current rate of inflation. The different lines are the inflation forecasts from different Monetary Bulletins of the CBI. The red line is the inflation target, 2.5%.

And has the Central Bank been accurate when it forecasts inflation? Not particularly so. But the inflation forecast of 3Q 2011 seems quite accurate, beside the fact that it's totally off in the beginning. Too bad they've changed their minds too often since then to really appreciate the accuracy of that forecast.

Forecasted inflation according to each Monetary Bulletin and the real measured value

As an example of a seriously flawed forecast, take a look at 2Q12 which came out in May 2012. At that time, they expected annual inflation to be 6.1% and 5.7% in end of 2Q12 and 3Q12 respectively. Notice that they are forecasting inflation for the same quarter (2Q12) as they are issuing it in. The measured annual rate of inflation was 5.4% in June 2012 and 4.3% in September 2012, way off of what was expected. Of course, once they had fed their forecasting model with the updated figures, the forecast was lowered.

Blatantly, nobody can take a forecast model which always expects inflation to go down to a predetermined figure seriously. All this is even funnier in the light of the Central Bank's self-praise in the "Post-crisis economic development and Central Bank forecasts" box in the newest Monetary Bulletin, pages 10-11. There, the Central Bank praises its November 2008 output growth (contraction really) forecast and says it was "virtually spot-on." This GDP forecast comes from the same model as the inflation forecasts.

Sure, the November 2008 forecast was too bad when it came to GDP growth. But I don't think the Bank is ever going to write the same sort of an egocentric self-praise when it comes to the July 2008 forecast where it foresaw that GDP growth would be -2.0% and -1.9% in 2009 and 2010 respectively. In reality, it was -6.6% and -4.0%. Well done boys and girls, you were so close!!

Furthermore, was the November 2008 forecast "virtually spot-on" when it came to inflation. Maybe it was as the model was accurate when it came to GDP growth. But I'm sorry, it was way off!

Not exactly the same accuracy in the inflation forecast of November 2008 as in the case of GDP growth. Notice that the model expects inflation to drop down to the inflation target in 7 quarters as it always does, no matter the current rate of inflation! 

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