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Endogenising the Inflation Forecast

RBA Assistant Governor Phil Lowe highlights an important change in the RBA’s technical forecasting assumptions:

For some years, it had been our practice to produce forecasts assuming that the cash rate remained unchanged throughout the forecast horizon. This approach had the obvious advantage of simplicity, but when the cash rate is a long way from its normal level, it is not particularly realistic.

So, in August last year we changed our approach. Since then, we have prepared our forecasts on the technical assumption that the cash rate returns towards a more normal setting over time. Our overall objective here is to provide the community with a general sense of how we think the economy is likely to evolve over the next few years and to do this we need to make realistic assumptions. Broadly speaking, the paths the staff have used have been similar to those implied by market interest rates at the time the forecasts were prepared. It is important to stress that this neither implies a commitment by the Board to the particular path used nor an endorsement by the Bank of the market pricing.

This is a welcome change.  It makes more sense for an inflation targeting central bank to forecast its own policy rate or to incorporate a market forecast for the policy rate and then base the inflation forecast on this projection.  This makes it more explicit that inflation outcomes are not exogenous under an inflation targeting regime.

There was also this endorsement of the macroeconomic benefits of increased labour market flexibility:

The good news is that this flexibility in employment relationships worked in limiting job losses in the economy. This has had obvious social benefits as well as supporting overall confidence in the community. Without this flexibility, it is likely that the outcomes would not have been as favourable.

posted on 18 February 2010 by skirchner in Economics, Financial Markets, Monetary Policy

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Here are the latest RBA measures of inflation:
CPI - 2.1%
CPI excl. volatile items - 2.4%
Weighted Median - 3.6%
Trimmed Mean - 3.2%

I understand they have constructed a couple of new ones.

The central bank executive moved to deflect recent criticism that the RBA had a haphazard approach to estimating trends in core inflation, confusing financial markets about the likely path of interest rates.

“It is important to point out that we do not have a mechanical approach. What we are trying to do is to discern the average rate of increase in prices, abstracting from particularly unusual movements,” Mr Lowe said.

“Since there is no single unambiguously ‘right’ measure, we look at them all. Then, using all the information at our disposal, we make our general assessment of the rate of underlying inflation,” Mr Lowe added.

The Australian

In other words, despite all the fancy maths, it all boils down to a subjective judgement.

Posted by .(JavaScript must be enabled to view this email address)  on  02/18  at  03:31 AM


The RBA need to adopt a measure and stick to it, at least for for so long as it remains useful.  There is nothing wrong with changing the measure from time to time as economic relationships change, but it should be done in a more transparent way that it has in the past.

Posted by skirchner  on  02/19  at  01:17 AM



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