Forecasting Inflation Under Uncertainty: The Forgotten Dog & the Frisbee (original) (raw)
2017, SSRN Electronic Journal
This study is an endeavour to analyse the aspect of adhering to simplicity instead of complexity when one is striving to make a forecast and faced with an unprecedented amount of uncertainty. There is substantial evidence on the exchange rate pass-through and its significant implications for the inflation in the United Kingdom. There is also ample evidence to suggest that the complex models of forecasting are outperformed by simple solutions and the use of heuristics. In that context, it seemed that the Bank of England forecast Post-Brexit is an example of the sub-optimal performance of complex models in the face of high tides of uncertainty. In order to illustrate our point further, we employed the data on the consumer price index from Jan 1989 to June 2016. We compared the Post-Brexit inflation forecast by the Bank of England with an ARIMA model and a simple rule which was based on the Bank of England's own estimates on pass-through due to exchange rate movements, similar in magnitude to the ones associated with Brexit. It showed that the actual path of inflation substantially diverged from the Bank of England's forecast as the effects of depreciation started to kick in. It implied that in a highly uncertain environment Post-Brexit a better prediction could have been possible by allocating some weight to the effect of sharp depreciation, indeed, that would have been considering the judgment and simplicity.
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