Models , Forecasting and the Transmission Mechanism of Monetary Policy Presentation to the

1. Models, Forecasting and the Transmission Mechanism of Monetary Policy Presentation to the Portfolio and Select Committee on Finance Cape Town 20 August 2004

2. Contents • Why do central banks need forecasts • General remarks about models and forecasting • Models used by the SARB • Communicating the forecast • The monetary policy transmission mechanism • Concluding remarks

3. Why Are Policy Makers Concerned With the Future? • Monetary policy works with a considerable time lag • Long time lags from changes in interest rates to output and from output to inflation • It differs across countries and over time • Policy makers wish to know what will happen if they change the central bank’s interest rate • Our knowledge about the MPTM is limited

4. Monetary policy and forecasts • Regardless of the monetary policy framework, a policymaker must have a view of the future because of the existence of transmission lags “Implicit in any monetary policy action or inaction is an expectation of how the future will unfold, that is, a forecast. There is no way to avoid making a forecast, explicitly or implicitly.” Alan Greenspan, 1994

5. General remarks on models

6. Central Banks & models • When sufficient data are available, central banks should make use of econometric techniques and of models: • To understand and quantify how the economy and monetary policy works (i.e. the transmission mechanism) • Monitor where the economy stands and make short-term projections • Make longer-term projections to determine impact of monetary policy CCBS Handbook in Central Banking, #3

7. Benefits of Models • Provide a simple framework with which to analyse and quantify short to medium-term macroeconomic developments • Assists in the construction of forecasts in a systematic and consistent manner • Useful for alternative policy simulations

8. Requirements for Models (1) • To capture structural changes in the economy • Not necessarily to supply precise forecasts, but at least a good indication of directional effects of policy options • To correspond to linkages in the economy and to track the dynamics in the model easily

9. Requirements for Models (2) • To follow a pluralistic approach: not one model for all occasions, but a suite of models • To follow a pragmatic approach: supplement model output with surveys, value judgements, etc. • To organise thoughts about policy and the economy, but their limitations must always be kept in mind.

10. Difficulties in modelling individual behaviour • A market economy is steered by decisions of millions of consumers and workers, and hundreds of thousands of managers, investors and entrepreneurs • A gigantic task to take account of the different circumstances in which each finds him/herself and the different choices and incentives they face

11. Modelling with and without theory • Econometricians learn from observing past behaviour of the economy as a whole, rather than individual behaviour • Econometrics is based on probability theory • used to test the validity of economic theory and • also to look for relationships with no underlying rationale in economic behaviour

12. Steps in model building • Literature study • Gather data and estimate individual equations • Model validation • Tests for system dynamics & stability • Test forecasting ability and accuracy: A lengthy process

13. A modern approach to modelling Data General empirical model Are the data I(0) or I(1) ? Economic theory I(0) I(1) Are there cointegrating relationships ? Yes No Estimation: - model in levels - model in first difference - ECM - VAR - VECM Data transformation Specification testing and diagnostic checking Is the model statistically adequate ? Yes No Tests of economic hypotheses Using the model for predictions and policy

14. Model evaluation Hold-out Period or Out-of-sample ex-post forecast ^ Y Estimation period or In-sample forecast Ex-ante forecast t t2004 t2000 t1980 Root mean square errors (RMSE’s)

15. Models used by the SARB

16. Structural and Atheoretical models developed and used by the SARB • Core model • Small-scale model • Phillips-curve model • Vector auto-regressive (VAR) model • Auto-regressive integrated moving-average (ARIMA) model • Indicator models • Disaggregated inflation model Assist in thinking about a wide range of issues in a structured and quantified way and fosters debate around modelling, forecasting and monetary policy issues

17. Core model • Keep relatively small: 63 equations of which 25 are structural equations • Focus on inflation and other key economic variables impacting on inflation • Economic theory determines long-run relationship between variables • No long-run trade-off between inflation and output • Short-run dynamics to explain short-term fluctuations in variables

18. Small-scale model • Highly aggregated: 5 equations • Easier to experiment with different behavioural equations • This type of model is used primarily by some central banks • Limitations in use of model

19. Phillips-curve model • Single equation model • Useful to describe the determinants of inflation and for inflation forecasting • Original concept relates to wage inflation and unemployment, but modern versions relate to price inflation and output gap • Cross-check forecasts derived from core model

20. Vector auto-regressive (VAR) model • Dynamic interaction between a set of variables • Do not require strong theoretical assumptions - model is rather based on actual trends in data • Useful over short time horizons • Primarily used for short-term forecasting (up to 4 periods) • Impulse responses describe reaction of variables on exogenous shocks

21. Auto-regressive integrated moving-average (ARIMA) model • Single equation model • Models a single variable in terms of an auto-regressive component and a moving-average component • Easy to estimate and solve the model • No strong theoretical assumptions • Useful over shorter time horizons • Disadvantage : ARIMA models cannot predict turning pointseasily as they are based on historical figures (or trends of the past)

22. Indicator models • Utilised to identify early indications of sources of inflationary pressure • Not used to forecast inflation • Effectiveness decreases as forecast period is prolonged • Currently 19 univariate models - monitor the monetary sector, foreign sector, labour market and domestic demand

23. Disaggregated inflation model • Model the components of CPIX independently • Uses monthly data • Possible to identify sources of inflation • Components are modelled mainly as a function of unit labour costs, import prices and the output gap

24. Forecasting process in the Bank • Intensive process spanning 6 weeks, 6 times a year : from information collection and analysis to final discussion at the MPC meeting • Collection and analysis of all relevant information on international and domestic economy • Initial assumptions by technical staff • Comments and suggestions by senior staff • Final assumptions and specification of alternative scenarios by members of the MPC • Preparation of forecasts with all the models and cross checking • Preparation of final MPC document • Discuss forecasts, risks and uncertainties at MPC meeting • Publish the inflation forecast in the MPR twice a year

25. Schematic illustration of the forecasting process in the Bank High Frequencydata OECD World Bank IMF Other SA SARB experts New data Formulation of assumptions Data update Add-factors update SARB experts Senior staff MPC Modelling Team Forecast reviews Final forecast locked in and alternative scenarios MPC

26. Role of forecasts “ In an ever-changing economy, no single model can possibly assimilate in a comprehensive way all the factors that matter for policy. Forming judgements about those factors, and their implications for policy, is the job of the Committee, not something that can be abdicated to models or even modellers. But economic models are indispensable tools in that process.” - Bank of England

27. SARB models and forecasts only one consideration in policy formulation Assumptions and judgements Core model Other models Other issues and policy judgements Forecast Policy

28. Communicating the forecast

29. Fan chart • Many central banks use a fan chart in presenting the forecast for inflation • A point forecast does not have much chance of matching actual outcome • Used to convey a more accurate representation of the assessment of medium-term inflationary pressures • Helps to focus the discussion on uncertainty & risks around the forecast • Fan indicates probabilities, NOT upper & lower bounds for inflation

30. Requirements for fan chart • The following inputs are required to construct the fan chart: • the outlook for inflation - based on the models • the degree of uncertainty - determines the width of the bands • the degree of skewness - upside or downside risk • Requires mode and median of distribution

31. Distribution around the forecast +50% Band Forecast -50% Band

32. Fan chart

33. The monetary policy transmission mechanism

34. The mystery of the MPTM “The tail wags the dog. By gently touching a tiny tail, Alan Greenspan wags the mammoth dog, the great American economy. Isn’t that remarkable? The federal funds rate is the shortest of all interest rates, remote from the rates on assets and debts by which businesses and households finance real investment and consumption expenditures counted in GDP. Why does monetary policy work? How? It’s a mystery, fully understood by neither central bankers nor economists.” James Tobin

35. The transmission mechanism • Describes how monetary policy affects output and inflation • When the official interest rate is changed: • By how much is inflation affected, and when? • Is output affected in the short-run? • Through which channels does this happen? • “To be successful in conducting monetary policy, the monetary authorities must have an accurate assessment of the timing and effect of their policies on the economy, thus requiring an understanding of the mechanisms through which monetary policy effects the economy” • (Mishkin, 1995).

36. Difficult to estimate • The lags with which monetary policy acts are long and variable (Friedman) • Our knowledge of the transmission mechanism is imperfect. • Estimating the transmission mechanism is difficult. (Mahadeva and Sinclair, 2001) • Lack of reliable data • Unforeseeable changes in the structure of the economy • Separating cause from effect in the data

37. HIGH E Importance of interest rate in transmission mechanism LOW HIGH DEPTH AND BREADTH OF FINANCIAL MARKETS

38. Market rates Domestic Domestic demand Asset prices inflationary Total pressure Official demand rate Net external Expectations/ Inflation demand confidence Imported inflation Exchange rate The transmission mechanism Bank of England Core model consistent with this view of the transmission mechanism

39. SARB diagram • The SARB view is similar to other central banks’ view of the MPTM • The starting point is again the official interest rate changes and then illustrate in more detail the key influences and channels running to the rest of the economy and ultimately to the rate of inflation. • Can create wrongly the impression that one can isolate the impact through these channels • Both diagrams essentially say the same thing • Main impact between 12 to 24 months, in line with international experience

40. Monetary Policy Transmission Mechanism Repurchase rate Capital movements Other interest Nominal Relative Money Other rates Nominal exchange prices and credit Money asset prices Other Relative rates exchange rate (equity, land, property) asset prices prices Change in reserves Expenditure Expenditure Inflation Net & Net & Inflation expectations Net wealth Investment & Net exports Import & Investment wealth exports prices Demand & supply Demand & supply Expenditure Demand & supply of goods and of goods and Expenditure & Import Inflation services of goods and Demand & supply services of goods and of goods and Investment & prices services of goods and expectations Investment services Demand & supply of goods and Wages Current of goods and services Wages Wages Account Inflation rate Inflation rate

41. SARB practice • Baseline forecast with fixed repo rate • Alternative scenarios • with “market expectations” repo rate • with Taylor-type policy reaction function • with alternative specifications by MPC • with alternative assumptions on ‘risk’ variables

42. Concluding remarks

43. Finally • SARB follows inflation targeting framework with a Monetary Policy Committee setting official interest rates • Model estimation procedures in line with modern approach to modelling • Model development process in line with international practice • Core model reflects the monetary policy transmission mechanism • Coefficients and impulse response functions are broadly in line with research findings of SARB and others • Forecasting process covers the various conventions of setting policy rates in models and the use of alternative scenarios • Forecast is a combination of staff and MPC inputs • Inflation forecast is published, using the fan chart to indicate uncertainty inherent in forecasting

44. Thank you