Investment Research General Market Conditions 24 February 2014 Euro Inflation Research #1 How the ECB makes its inflation projections Mario Draghi has hinted that the new 2016 forecasts due to be published at the ECB meeting will prove instrumental in near-term policy decisions. This renders the question of what inflation outlook the ECB staff will put forward pertinent. Here we consider the ECB projection procedure including key forecasting model properties. In four upcoming documents we intend to consider what to expect of the 2016 staff projections and in turn the likely policy reaction. The ECB makes its projections by use of econometric models, which following a shock by definition will return to target/steady state in the longer term. How long this adjustment process lasts depends on the type of shock. In this paper we investigate two types of shocks. The first is a supply shock, which is a key factor in the ongoing fall in headline inflation. In this case it takes around two years before inflation is back to target. Euro inflation research 1. How the ECB makes its inflation projections, 24 February 2. ECB s current inflation forecast, 25 February 3. ECB s medium-term outlook for inflation, 26 February 4. ECB s reaction function, 27 February 5. ECB will ease again, 28 February The second shock studied is a complex negative demand shock, which reflects a demand and government consumption shock mainly in peripheral countries. The conclusion is that it takes longer than two years before inflation is back to target. Although the models may seem abstract, it is important to realise that when forecasting medium term inflation these types of models form the foundation for ECB. Role of projections within the monetary policy strategy The ECB generally describes its use of its economic projections as follows Projections play an important but not all-encompassing role in the ECB s monetary policy strategy. At the ECB meeting in February, Draghi described the decision not to act as due to lack of information and underlined the importance of the 2016 projections for future policy decisions as he said these forecasts are a very significant change in our analysis, a significant change in the information set that we use for our analysis. What are the drivers of inflation? CPI Core Food & energy Output gap Import prices Commodity demand Commodity supply National growth Long-term inflation expectations Global (EM) growth Senior Analyst Christin Tuxen +45 45 13 78 67 tux@danskebank.dk Structural reforms Source Danske Bank Markets Fiscal policy Monetary policy/credit Productivity Demography Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
That communication shows that the ECB is very focused on the medium-term outlook and it could indicate that it will abstain from easing again, if inflation is set to return towards the 2% target in 2016 even if inflation remains far below the objective in the short term. Thus, the question of what inflation forecast the ECB staff will put forward is very pertinent. Moreover, the projection for 2016 can be used as a way of strengthening the ECB s forward guidance. ECB inflation projections a mix of models and judgement In A guide to Eurosystem staff macroeconomic projection exercises, the ECB sketches the forecasting process that ECB staff go through four times a year 1. Essentially, this process has three steps. Setting underlying assumptions on interest rates, exchange rates, commodity prices, international developments and fiscal variables (see box below). The national central banks make initial projections for their own country, while the ECB staff separately prepare projections for the individual countries and the aggregated euro area. The projections are derived using a combination of economic indicators, model projections and judgmental assessments. Preparing the report for the Governing Council. ECB s underlying forecast assumptions The provisional assumptions set in the first step largely condition the analysis on market expectations for the variables in question. Commodity prices: The oil and non-energy commodity prices are based on the future market. Interest rates: The assumption about short-term interest rates is of a purely technical nature, whereas long-term interest rates are projected in line with market expectations. Exchange rates: Bilateral exchange rates are set in line with recent values and assumed to remain constant over the projection horizon. Fiscal variables: The fiscal policy assumption is based on individual euro area countries prevailing national budget plans and include only policy measures that have been approved by national parliaments. Source: A guide to Eurosystem staff macroeconomic projection exercises Properties of ECB s econometric model In deriving the projections, the ECB staff make use of a range of conjunctural and econometric models. The former includes various methods of assessing the current and future stance of the business cycle using, for example, coincident and leading indicators. Importantly, they also employ medium- to large-scale econometric models and these are likely to play a bigger role in pinning down the forecasts the longer the forecast horizon. Hence, the features of these might play a non-negligible role for the upcoming 2016 projections. The models are typically structural in nature, implying that certain fundamental economic relationships are assumed to hold in the longer run. Two such econometric models likely to play a prominent role in arriving at 2016 forecasts are the New Area Wide Model (NAWM) and the New Multi Country Model (NMCM); the latter is essentially a five-country version of the former, with largely the same underlying properties as its area-wide version. Both models are DSGE type in nature, meaning they are based on assumptions at the micro level regarding economic behaviour 1 In June and December, the ECB publishes the Eurosystem staff macroeconomic projections, while in March and September the forecasts are complemented by the ECB staff. The techniques used in the ECB staff projections are consistent with those of the Eurosystem staff projections described here. 2 24 February 2014 www.danskeresearch.com
of firms and households and set to converge in the longer run to an equilibrium determined by supply-side factors. Although this implies that inflation is forced to return to target relatively quickly in the face of shocks, the model at the same time incorporates some sluggishness in price-wage formation. The NAWM supersedes the previously employed Area Wide Model (AWM), which is a traditional large-scale macro-econometric model with a range of error-correction features (similar in type to, for example, the MONA model of Danmarks Nationalbank). Compared with the (old) AWM, the NAWM adheres more strictly to theoretical (rather than empirical) relationships, which make, for example, inflation potentially return to target more rapidly. In order to gauge what the model suggests in terms of inflation and the implied policy reaction, we consider a positive supply shock and a (somewhat complex) negative demand shock. A positive supply shock We first look at the model-implied effects of a transitory (positive) technology shock. This is arguably not too far from capturing a key feature of the positive supply shock that we have previously argued is a key factor behind the ongoing fall in headline inflation on a global scale and which derives largely from a production boom in the energy sector (see, for example, Deflation is not always a bad thing and FX Top Trades 2014). As discussed in ECB Working Paper no. 944, a temporary positive technology shock causes real marginal costs to fall and thus induces a fall in domestic prices. We note that this shock boosts GDP but weighs on employment as the shock increases labour productivity. Two factors limit the need for the central bank to cut rates in this case. First, real interest rates rise in the short term due to the fall in inflation and mitigate the rise in domestic demand. Second, currency depreciation lifts the prices of imported goods. Both forces partly counteract the fall in inflation and, in this scenario, a 0.2pp fall in consumerprice inflation requires the nominal interest rate, set by the central bank, to be lowered by little more than 0.05pp. Notably, within the model it takes around two years before inflation is back to target. (Note in the charts below real GDP is measured in percentage deviation from model steady state, while inflation and interest rates are measured as annualised percentage-point ). Supply shock effects on: real GDP CPI inflation Nominal interest rate (set by the central bank) Note; Measured in percentage deviations from model steady state 3 24 February 2014 www.danskeresearch.com
Complex negative demand shock The current eurozone disinflation is not purely supply driven however: a key factor behind the fall in core inflation relates to ongoing adjustments in wages and prices in peripheral countries. This type of shock is arguably somewhat more complex than the model allows for and may be characterised as an uneven combination of a demand shock, a cost-push shock and a government consumption shock all in a negative direction. Indeed, activity/wages/prices are declining as a result of a structural adjustment process fuelled not least by a fall in government consumption. The non-straightforward nature of the shock driving down core inflation and that it is directly relevant only for a limited set of euro area countries makes it difficult to address within the NAWM. However, what we can say is that a shock to government consumption generally leads inflation to deviate from target for longer than two years despite a negative shock and induced disinflation forcing the central bank to cut rates; one reason is that in this case both GDP and employment are adversely affected (contrasting with the technology shock above), reinforcing deflationary effects. Note the model scenario depicted below shows a positive government consumption shock (and signs must be reversed for our purpose). Fiscal shock effects on: real GDP CPI inflation Nominal interest rate Note: Measured in percentage deviations from model steady state It should be kept in mind that the model-implied scenarios sketched above are very stylised in nature and should not in any case be viewed as a straight guide to a likely ECB reaction to falling inflation. That said, to sum up, on the one hand, the supply side of the disinflation story suggests the ECB may see inflation return to target relatively quickly at least to the extent that the shock is temporary (which it may not be if one believes in a continued slide in commodity prices for years to come as we do). On the other hand, the demand part of the story suggests it may take much longer than two years for inflation to revert to target at least in the periphery in the absence of a significant ECB reaction. We plan to discuss the implications of this for the ECB s likely medium-term outlook for inflation in an upcoming document titled ECB s medium-term outlook for inflation. To the extent that the Governing Council is worried about a continued fall in commodity prices (as we expect) and/or about the likely prolonged impact (according to the NAWM) of the structural adjustments deriving from a negative fiscal shock, then ECB action is pertinent. However, Draghi may be relatively complacent in this respect, as he has said much of the decline in core inflation, actually comes from the four programme countries...this would signal more of a relative price adjustment than of a deflation phenomenon. We will discuss this in the documents we plan to publish this week. 4 24 February 2014 www.danskeresearch.com
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