What Do Central Banks Know about Inflation Factors?

Abstract

We offer a novel methodology for assessing the quality of central bank monetary policy reports. We evaluate their economic content by comparing verbally reported inflation factors with factors identified from a simple new Keynesian model. Positive correlations indicate that the reported inflation factors were similar to the model-identified ones, marking high-quality inflation reports. Although sample bank reports on average identified inflation factors correctly, the degree of forward-looking reporting varied.

Appendices

Appendix 1: Coding the Monetary Policy Reports

We extracted forward-looking verbal assessments and coded the presumed direction thereof on inflation. Each entry was reviewed and checked by two co-authors to ensure consistency and limit subjectivity, with less than one-tenth of the initial entries being reassessed. The ternary coding of inflation factors, −1, 0, +1, proceeded in two steps. First, each comment was catalogued into a major category and a subcategory: demand (fiscal, domestic cycle pressure, wages, external demand, domestic asset price bubbles, other), supply (weather and similar shocks, oil/gas prices, agricultural prices, labor supply, regulated prices, structural changes, retail competition, indirect taxes, other), or external (exchange rates, global financial shocks, other). Second, factors putting upward/downward pressure on inflation were denoted as +1/−1 and neutral/unclear factors were denoted as 0.

Below are typical examples of our coding. The March 2003 ECB Monthly Bulletin contained the following sentence: “the moderate pace of economic growth should reduce inflationary pressures” and was coded as −1 in the demand category. The January 2003 issue noted “increases in administered prices,” and was coded as +1 in the supply category.

Table 5 Sample country characteristics

Appendix 2: Inflation Accounting

For each country we build a country-specific NK model, see Bulíř et al. (2014) for the model structure and calibration details, and then solve it for its reduced form, substituting non-predetermined forward-looking variables with a linear combination of past shocks. The reduced-form of the model serves as a starting point for the estimation of economic shocks using the multivariate (Kalman) filter and the filter extends the model’s reduced form to measurement equations that map observed variables to the unobserved ones:

$$ {y}_t=Z{x}_t+{\varepsilon}_t $$

(1)

$$ {x}_t=T{x}_{t-1}+{\nu}_t, $$

(2)

where x denotes the vector of unobserved state variables, y is the vector of observed (measurement) variables, ε is the process noise, and ν is the measurement noise. Conditional on the state form of the model and the observed variables, the Kalman filter identifies all unobserved variables and shocks. For linear systems the Kalman filter represents an optimum estimate in terms of the least squares criterion (Hamilton 1994). As some variables are nonstationary, without finite value variances, we employ the diffuse Kalman filter. Finally, we employ the smoothing step of the filter using the complete information (Harvey 1989).

The estimated realizations of various shocks are used for historical simulations of the model, quantifying their exact time-varying effects on inflation as in Smets and Wouters (2007). Deviations of inflation from its target are due to six unobserved components, each defined as a deviation from its steady-state value: aggregate demand, aggregate supply, the exchange rate, foreign variables, trends, and monetary policy. To this end, we recursively simulate the model using the estimated state variables, while adding only one particular sequence of estimated shocks. Inflation deviations from the target caused in the model simulation by one sequence of shocks are what we call model-identified inflation factors, capturing the interaction of each shock and the transmission mechanism. The recursive simulations are repeated for all sequences of shocks, providing us with estimates of the impact of demand, supply, exchange rate, and other shocks on the deviation of inflation from its target. By summing up all the inflation factors we recover the actual inflation rate.